3 Top Defense Sector Stocks

Welcome back to Defense Investing 101, Fools.

Over the past few weeks we've been discussing a variety of ways to invest in the defense sector. We've looked at which American defense contractors have the best products for solving the problem of Somali piracy. We've discussed Defense Secretary Gates' latest Pentagon budget proposal. We've laid odds on who should win (and lose) based on how they help fight the ground wars in Iraq and Afghanistan, the naval war in the Gulf of Aden, and the cyberwar here at home. And we've discussed which companies stand best positioned to profit from these trends in years to come.

There's just one question we have not addressed (and for good reason). That question is...

Valuation
A wise Fool once told us that valuation matters in investing -- and it does. The problem with valuation, though, is that it changes from day to day.

I'm not just talking about stock prices. The last few months have given us all a refresher course in just how truly manic-depressive Mr. Market can be. But what I'm talking about is the numbers that companies produce themselves -- their performance.

Every three months, stocks undergo the ritual of earnings season, updating us on their latest tallies of profit and loss. Only with these numbers in hand can we compare the stock prices and decide whether we're being asked to pay a fair price for the company. But with all the major defense contractors having finished reporting their first-quarter results, we've finally got some hard numbers to work with. Now we can figure out which of these companies are not just poised to profit from the business they're in -- but priced to provide you some profit as well.

Let the hunt for value begin.

Company

P/E

P/FCF

5-year Projected Growth Rate

Backlog ($billions)*

Raytheon (NYSE: RTN  )

10.9

8.6

11.7%

37.9

Lockheed Martin (NYSE: LMT  )

9.8

8.2

10.9%

80.8

General Dynamics (NYSE: GD  )

8.9

9.4

9%

71.1

L-3 Communications (NYSE: LLL  )

9.0

7.1

8.7%

11.7

Northrop Grumman (NYSE: NOC  )

n/a

7.3

11.1%

76.9

United Technologies (NYSE: UTX  )

11.3

10.8

9%

60.0

Boeing (NYSE: BA  )

15.7

n/a

8.2%

339.4

*Backlogs as reported by Standard & Poor's division CapitalIQ as of Q1 2009, or, when data is missing, as reported in the firms' own 8-k earnings filings (except in the case of United Tech which did not contain such data); in UT's case, backlog data is current as of Q4 2008.

Backlog
Before running down the results, a couple comments on the subject of backlog are in order. Every company reports its backlog differently. L-3, for example, reports only the highest quality, funded backlog. Boeing gives a detailed backlog breakdown of funded and unfunded backlog -- but it also recently provided us a case study in how quickly backlog can evaporate when a single big customer gets a case of the willies.

Still, the data we see above does seem allay fears that President Obama will be the ruin of defense investors. To the contrary, what we see here is an industry in the peak of health. L-3's anomalous number aside, the worst company above looks to be United Tech, yet even UTC has more than a year's worth of work on its books. Most of these companies have at least two years' worth of work laid out for them, and Boeing in particular (see caveat above) has enough work to keep it busy for the next five-and-a-half years.

Nice.

Somebody's got to lose...
Regardless, I put Boeing at the bottom of the list for three reasons. First, it's burning cash. Second, its P/E looks too high relative to growth. Third and perhaps most importantly... that same backlog which gives us such a clear view of Boeing's future is also visible to analysts. And this increases the chance that they're right when they tell us that Boeing has the worst (i.e. slowest) growth prospects of any company in this industry.

United Tech, Northrop, and L-3 join Boeing at the bottom of the list because for various reasons, ranging from mild overvaluation (United Tech) to weak GAAP numbers (Northrop) to apparent weakness in backlog (L-3). Additionally, United Tech and LLL carry debt loads that are relatively higher than the rest of the group, although the industry as a whole looks well capitalized.

... while three somebodies win
Raytheon, Lockheed, and General Dynamics carry strong balance sheets, while their valuations appear attractive relative to their growth prospects. Looking out over the coming decades, I expect we'll see Raytheon continue to enjoy strong growth in its core business -- and don't be surprised if its purchase of the rights to the KillerBee UAV pays off in spades. Lockheed obviously has the F-35 fighter jet under its wing. And General Dynamics -- well, you can't go wrong owning the undisputed king of armored warfare at these prices.

Foolish takeaway
Mind you, I have great admiration even for the "losers" in today's column. I respect United Tech's management in particular. L-3 tempts me with its price and its five-star CAPS rating, Northrop with its growing dominance in unmanned aerial vehicles, and Boeing -- heck, I actually own Boeing, having picked up a few shares back when its prospects looked better.

But if you want to know which three firms look best today, then here they are: Raytheon, Lockheed, and General D. Give 'em a hand, folks, and consider giving them a place in your portfolio.

Victory through superior defense sector investing:

And if you want the very best in Foolish defense investing ideas, check out Motley Fool Rule Breakers, where we're looking into options for everything from flying model airplanes, to bomb-proof trucks, to bulletproof soldiers. We never intended to become the "defense contractor" newsletter -- that' s just where the opportunities seem to be. 30-day trials are free.

Stock news, financial commentary, and your daily dose of Foolishness: Get plugged in to The Motley Fool on Twitter!

Fool contributor Rich Smith owns shares of Boeing. The Motley Fool's disclosure policy is the ultimate force multiplier.


Read/Post Comments (2) | Recommend This Article (18)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On May 19, 2009, at 6:00 PM, Warpaint13 wrote:

    I feel compelled to point out a couple of accounting basics. GAAP requires most R&D effort to be expensed in the current period, rather than capitalized. When you look at the extreme R&D spending Boeing has gone through over the past 3 years with 787 development... and the new Freighter and Tanker programs... not counting military research... you realize that the profit margins shown... were heavily weighed down by those expeditures, not to mention the unusually impacting strike last year. You can also see that the majority of that R&D burden is now winding down. That draws a couple of things immediately into focus. First, it's rather impressive that despite all of that... the PE ratio is ONLY 15.7; and second... the PE ratio is likely to take a dramatic dive in the very near future... as those expenditures tail off... and the highly leveraged profit margin begins a steady, steep increase. Plus... given the 5.5 year backlog... and that it is unlikely that BA will sit on its marketing laurels... for the next 5 years... as we ease out of the recession... and 787... with it's unparalleled passenger-miles-per-gallon performance... becomes even more attractive... as oil prices begin to climb (again) in response to the recovering economy. In short... the value is not in what the PE ratio looks like today... it is... in what it is likely to look like... as the economy and the recent cycle of heavy, new product development... play out... The most important criteria in investment success is "timing", Given that we are at the cusp of those cashflow & product mix transitions, new potentials are in the process of forming.

  • Report this Comment On July 21, 2009, at 4:05 AM, defensevc wrote:

    I posted this to the other article about profiting from "myopia." I think the same applies here to a deeper consideration than just the big defense stocks.

    If you really want to look beyond examine how the Government and the different services are motivating & even placing direct investments in the technologies that are most important to them over the long term. Advanced materials, battery tech, energy/transmission (the first long range electric vehicle will carry soldiers!), knowledge management, complex event processing, biodefense & detection... check out http://www.defense-ventures.com for leading commentary on future defense & security developments.

Add your comment.

DocumentId: 902609, ~/Articles/ArticleHandler.aspx, 7/25/2014 10:25:43 AM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...


Advertisement