There are a lot of things that come to mind when you hear the term "defense stocks," but rarely do you hear "defense stocks" and "market-beating returns" in the same sentence. Defense, as an industry, tends to be a slow and steadily growing business that can wax and wane with congressional purse strings.
Sure, you can find lots of defense businesses that will generate positive returns over long holding periods. Market-beating returns, though? Those opportunities are harder to come by in this sector. If you are looking for the reliability of having the U.S. government as a business' largest customer while also having a shot of beating the market over the next decade, then here's why you might want to consider Lockheed Martin (LMT 1.16%), CACI International (CACI 0.69%), and Booz Allen Hamilton (BAH 0.93%).
Lockheed F-35 fighters. Image source: Getty Images.
Betting on those that have done it before
If you are betting on a company generating market-beating returns, you can do it two ways: You can invest in young, growth-oriented companies that have the potential to beat the market, or you can invest in mature businesses that have established track records of outrunning the market. Neither one is right or wrong, but the chances of a business with an established record continuing to do what it has for years is much greater than one that has not yet done it.
That is what makes these three defense stocks compelling. All three have generated total returns (dividends plus share price gains) that have beaten the S&P 500 total return over the past decade.
A cash (jet) engine to fuel future growth
At first glance, Lockheed Martin doesn't look like the kind of company that can generate those market-crushing returns, especially after an anemic 2021 and expectations for a flattish 2022. If you back out the lens, though, you can see ways in which the company can create shareholder value over the long term.
Lockheed's flagship product is the F-35 fighter jet, which constitutes about $17 billion in annual sales. After years of research and development, the capital expenditures needed to develop this program are a fraction of what they were, and it allows the company to invest in other high-priority defense needs, one of them being hypersonics.
Forecasts for F-35 orders indicate steady revenue for the next five years, which should give the company ample time to win new contracts and develop what could be new multibillion-dollar programs.
What is most promising for investors, though, is that management expects to return about $15 billion to shareholders in the form of share repurchases and dividends over the next several years, and $6.6 billion of those buybacks should come in the next 12 to 18 months. Buying back shares has been an effective way to turn modest revenue growth into outsize earnings-per-share growth in the past, and it looks like management will continue to run this playbook to the benefit of its shareholders.
Image source: Getty Images.
Quietly creating incredible shareholder value
CACI International rarely gets attention as a defense contractor. That's largely because it doesn't have one of those big, recognizable products like a fighter jet or tank tied to it. Rather, CACI focuses largely on information technology (IT), network capability, and cybersecurity for defense and non-defense government agencies. It also provides support to intelligence-gathering entities with logistics and reconnaissance.
The combination of increased cyberthreats, growing digital intelligence gathering, and massive IT upgrades to government systems provides CACI with plenty of opportunities to grow the business. Over the past three years, the company has achieved a book-to-bill ratio of 1.5 or greater each quarter, meaning that the amount of future dollars coming in the door from new contract awards has been at least 50% higher than the amount it charged for providing service under its existing contracts. As of the most recent quarter, its contract backlog of $24 billion is more than four times its annualized revenue, and it expects to bid on another $14 billion in contracts over the next two quarters.
In addition to winning new contracts, CACI's management has significantly grown the business by acquiring smaller contractors or parts of larger defense contractors that fit well into its portfolio. The combo of a robust contract backlog and acquisitions has led to spectacular growth as the company has increased free cash flow per share by 19% annually over the past five years. What's even more enticing is that the stock trades at the lowest price-to-earnings ratio of these three defense contractors at 14.8 times, a very reasonable price for a stock with a track record of outperforming the market.
LMT total return price. Data by YCharts.
Million-dollar contracts here and there add up quickly
Booz Allen Hamilton is very much in the same vein as CACI as a defense contractor. It isn't known for headline-grabbing hardware contracts and is largely responsible for back-office support tasks like updating digital infrastructure, management consulting, and data analytics. It is also one of the largest government contractors offering artificial intelligence and quantum computing services to the Department of Defense.
One thing that separates Booz from many other defense contractors is that it generates the bulk of its business (more than 80%, according to its most recent 10-K) from indefinite duration/indefinite quantity (IDIQ) contracts. Unlike big-budget programs such as fighter jets or lump-sum contracts for IT upgrades, IDIQ contracts don't commit the government to a set level of spending and allows it to buy products or services on demand. These are beneficial for Booz Allen Hamilton because IDIQ contracts tend to be a much more streamlined bidding process with fewer competitors. The company occupies a valuable position in the government contracting ecosystem, having had a book-to-bill ratio above 1.2 for the past five years.
Booz's value creation for shareholders looks much more like CACI's approach than Lockheed's. While Booz does pay a modest dividend, most of its shareholder return has come from growing the business through contract awards and acquisitions.
Management is projecting it will grow annual earnings before interest, taxes, depreciation, and amortization (EBITDA) from $800 million over the past 12 months to a range of $1.2 billion to $1.3 billion by 2025 through a combo of single-digit revenue growth, margin expansion, and acquisitions. It is a playbook that the company has executed well for the past decade, so investors can be reasonably confident in Booz Allen Hamilton doing so for another decade.
