With all the recent posturing in Washington over the federal deficit, one thing seems certain: Federal spending will probably slow, to one degree or another. However, investors in certain government-reliant segments have long anticipated this budgetary blitzkrieg, evacuating those industries and firms they deem most vulnerable.
Enter the defense industry. You could argue that no other industry has spent more time in skittish investors' crosshairs. The budget hoopla and the beginning of the end of two wars abroad have convinced the market that these companies are due for a shelling in their own right. However, as I've argued on several occasions, I think investors might have significantly overreacted to how soon those problems will come home to roost. Given how cheap some stocks in this sector currently appear, I enlisted some of our foremost defense analysts to pitch their best stock ideas.
Rich Smith, Motley Fool contributor
My favorite defense stock has gotta be Lockheed Martin (NYSE: LMT ) -- last year, this year, and for the next 50 years.
Last year, I nominated Lockheed as one of the 10 "core" stocks that deserve a place in any investor's long-term portfolio. While Wall Street worries about how budget cuts will affect the defense industry, Lockheed to me looks like one of the few companies that will fly through the turbulence unharmed.
Over the next several decades, the U.S. Army, Navy, Air Force, and Marines will phase out their multiple ground-attack and air superiority fighter jets in favor of a single common combat plane: The Lockheed Martin F-35 Lightning II. Lockheed beat out Boeing (NYSE: BA ) for the right to build the F-35, and according to Joint Chiefs of Staff Chairman Admiral Mike Mullen, there won't be another contest for manned fighter jets … ever. The military's shifting its focus for new product development to UAVs, giving Lockheed a virtual lock on fighter jet production for the next half-century or so.
This budding military monopolist costs less than 10 times earnings, is growing profits at better than 9% per year, and pays shareholders a 3.7% annual dividend. I think it's a bargain. (Oh, and Lockheed reports earnings on Tuesday -- so if you're interested in it, you can get even more up-to-date info on Lockheed in just a few days. Add Lockheed to your watchlist and catch the news first.)
Katie Spence, Motley Fool contributor
Admittedly, Northrop Grumman (NYSE: NOC ) is nowhere near as big as competitor Boeing, but what it may lack in size, it more than makes up for in investor friendliness. Its financial performance and fine management make this company a definite “buy now.”
Since 2010, Northrop's sales increased from $33.8 billion to $34.8 billion. Earnings per share from continuing operations increased 39%. And the company raised its quarterly dividend in May by 9.3%. That's Northrop's seventh consecutive annual increase, and with a payout ratio of 26%, it's completely sustainable.
Thanks to strong cash flow, Northrop Grumman also repurchased 19.7 million shares. That not only signals management's faith in the company's continued growth, but also raises the value of each share by assigning it a greater slice of the company's earnings.
Want more reasons to buy now? Currently, Northrop Grumman's P/E is 9.21. When you compare that to Boeing's P/E of 15.75, Northrop Grumman looks like a sweet deal.
As if that weren't enough to seal the deal, remember that management I mentioned? Wesley Bush, Northrop Grumman's new CEO as of 2010, brings to the table more than 25 years of aerospace and defense experience. Moreover, Bush has placed a strong emphasis on creating value for investors. That may look a little self-serving when you consider that Mr. Bush owns a large chunk of shares himself. But when you also consider that creating value for investors means growing the business, suddenly that self-serving attitude seems pretty appealing to outside investors.
Andrew Tonner, Motley Fool editor and contributor
For my selection, I moved slightly down the market-cap scale to the smaller, but still relevant L-3 Communications (NYSE: LLL ) . In my mind, surviving and thriving in defense requires investors to concentrate on companies that already operate in areas of future importance, such as unmanned aircraft and cybersecurity. While they won't guarantee future success, early adopters should at least stand a better chance of carving out strong presences in these areas, and L-3 is no different. It already has solid placement across the defense technology spectrum, including cybersecurity, an area the DoD has explicitly cited as a key future priority.
L-3 has a history of solid past performance to support its case as a well-run contractor, generating consistently respectable returns on equity and operating margins. It has a safe balance sheet with a debt-to-equity ratio of only 60%. It has a history of consistently paying out and growing its dividends.
However, L-3 becomes more compelling when you start examining the multiples for which it currently sells: 10 times earnings over the past 12 months, 9.4 times next year's expected earnings, and 7.1 times its last 12 months' cash flow.
Consider that competitors Textron (NYSE: TXT ) and United Technologies (NYSE: UTX ) sell for 17.6 times and 15.4 times their next 12 months' earnings, respectively. Meanwhile, the S&P 500 currently trades at 16.3 times earnings. In comparison, L-3 looks pretty darn cheap. Judging by the overall price-to-value equation, you get a well-run, established defense player that's strategically aligned with the future of its industry, all for a bargain- basement price. That seems to me like the kind of low-risk bet that value-oriented investors love.
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