Better Buy: Raytheon Company vs. Huntington Ingalls

Raytheon (RTN) and Huntington Ingalls (HII -0.88%), though both major Pentagon contractors, offer two very different profiles to potential investors. Huntington Ingalls is at its heart a metal-bender, a shipbuilding specialist responsible for the Navy's massive carriers and a significant portion of the rest of the fleet. Raytheon meanwhile doesn't make any of the tanks, planes, or ships that show up on military recruitment posters, but its electronics, sensors, and missiles can be found on seemingly every weapons system the Pentagon deploys.

Raytheon is also a much larger company than Huntington Ingalls, generating three-times the revenue and commanding a market capitalization five times greater. But its shares are also more expensive on both a price-to-earnings and price-to-sales.

The companies do have similarities, notably they both figure to be among the major beneficiaries of an ongoing surge in Pentagon spending.

Here's a look at the outlook for both Raytheon and Huntington Ingalls, to determine which, if either, is the better buy today.

Source: Yahoo! Finance. Data as of July 27, 2018. TTM = Trailing-twelve months

Rockets firing

Raytheon is a defense specialist focused on areas including precision weapons, anti-missile systems, sensors, and radars, areas of particular interest to the Pentagon and U.S. allies. It's sensor business earlier this year beat out Northrop Grumman to win a high-profile award to supply a sophisticated camera system for Lockheed Martin's F-35 fighter, and its radar units are also the eyes behind Lockheed's THAAD anti-ballistic missile system.

A Raytheon-made Tomahawk cruise missile. Image source: Raytheon.

The company is also the most diverse U.S. prime contractor in terms of international sales, with foreign customers accounting for about one-third of total revenue and more than 40% of its backlog. Raytheon's Patriot missile systems are deployed across the Middle East and in a growing number of European countries.

Raytheon on July 26 reported a second quarter beat thanks to growing missile sales and increased classified work and hiked its fully year revenue guidance by $1 billion to between $28.5 billion and $29.5 billion in sales. The company expects significant orders in the second half of the year for its Tomahawk, Griffin, and other missile systems, but if anything remained conservative on the timing of foreign Patriot and radar orders that could offer additional upside for late 2018 or into 2019.

Caution about foreign sales is advisable, as after a three-year run that saw shares of Raytheon more than double investors of late have been growing increasingly concerned that tough talk from the White House on tariffs and toward NATO would cause some of the U.S.'s closet allies to invest in domestic programs instead of buying U.S. armaments.

Raytheon has argued that its missile systems are somewhat immune to those pressures because of their superior performance on the battlefield, but in the current climate it is likely best not to over-promise.

Investors were also concerned with Raytheon's 2018 cash flow projections. The company said it made a $1.25 billion pension contribution designed to take advantage of tax cut legislation and cut its 2018 effective tax rate from an estimated 18% to about 10.5%. Because of that contribution the company said it expects full-year operational cash flow from continuing operations to come in at between $2.6 billion and $3 billion, down from an earlier estimate of $3.6 billion or $4 billion.

Shares of Raytheon fell 3% in the hours after that cash guidance was released. They recovered much of that loss as the day went on, but the drop can be read as some investor nervousness that after a few good years there might not much further for Raytheon to climb.

Safe harbor

Huntington Ingalls, with vast shipyards in Newport News, Va., and along the U.S. Gulf Coast, is perhaps the best positioned company to take advantage of White House plans to rapidly expand the size of the U.S. Navy in the years to come. While the stated goal to grow the fleet by more than 25% to 350 vessels might not be realistic, it is clear a steady stream of new orders will continue to roll in and additional refurbishment work will be available as the Navy tries to keep existing ships in service longer.

Huntington Ingalls-built USS Gerald R. Ford. Image source: Huntington Ingalls.

Huntington shares, similar to Raytheon, have doubled over the last three years on excitement about increased spending, but also like Raytheon there has been a pullback of late. Shares are off more than 10% from their peak earlier this year after first quarter results raised questions about whether the stock had run too high too quickly.

The logic behind the run-up was solid, as Huntington can boast a backlog of more than $20 billion in projects and hopes to grow revenue by 3% annually over the next five years. CEO Mike Petters, on a call with analysts in May, said this is "the most exciting shipbuilding environment in over 30 years."

RTN and HII data by YCharts

But Huntington Ingalls is in the early stage of some of its key multiyear procurements, and shipbuilding by its nature tends to not be as profitable early in a contract as ramp-up costs are high and margins tend to come under pressure. If the steady flow of new business continues as expected it might be some time before Huntington Ingalls has the more mature product mix that usually leads to higher profits.

All that business and the promise of future earnings is a great problem to have, but it could lead to some choppy sailing for investors in the quarters to come.

The better buy is...

It's easy to make the case that both of these companies are solid stocks to hold, both possessing strong management teams, clear strategies, and a reliable, predictable path to grow both revenue and earnings. However, neither is a clear buy at this moment.

It remains to be seen how quickly all of the new business Huntington Ingalls expects will impact the bottom line, and if the price drop after last quarter's earnings report is any indication Wall Street is in no mood to wait it out. Raytheon meanwhile appears a better bet to show real earnings momentum over the next twelve months, but the stock is already trading at lofty levels, trailing only Lockheed among defense primes in terms of price-to-earnings.

If forced to choose today I'd buy into Raytheon and hope that with business showing no sign of slowing down the current multiples can be sustained as earnings grow, though I still believe there are better bargains to be found in the defense patch.

These are two solid companies, but it is far from certain that either will be able to outperform the market over the quarters to come.