What's in Store for These Defense Contractors?

Defense companies have been dealing with headwinds for quite some time now, and further budget cuts loom. Exposure to the U.S. government was once a plus for defense companies, since it meant stability and growth. These days, increased commercial and international revenue is the name of the game, since the government is unlikely to increase the defense pie anytime soon. Despite these headwinds, I would still watch developments in this space. Valuation multiples are very low across the board, so it's quite hard to stay away without peeking in.

Cheap valuation, plenty of free cash flow
Last week, L-3 Communications (NYSE: LLL  ) reported 2011 sales of $15.2 billion, down 3% from 2010. The book-to-bill ratio for the full year was 0.97, signifying that the company could not book more orders than it had in sales. That's not very surprising, given the tough operating environment. For the year, the company returned $1.1 billion in cash in the form of share repurchases and dividends in 2011, quite a hefty sum given the company's market cap of just over $7 billion. 

In fact, what I like about this company is the steady free cash flow generation paired with its cheap valuation. This has enabled the company to repurchase its shares at an incredible rate: 13.6% of shares outstanding have been retired in just the past two years. As long as investors continue to shun shares of defense companies, this is likely to continue. Over the longer term, since the inception of L-3's share repurchase plan, about one-third of the company's outstanding stock has been retired.

So far, the company projects 2012 sales of $14.4 billion to $14.6 billion, which would represent a decline of 4% to 5% versus its 2011 figure. Most of that is related to the US military drawdowns in Iraq and Afghanistan. For the year, free cash flow is expected to be just under $1.2 billion, which implies a price-to-FCF multiple of less than 6 on the stock. That's an extremely low multiple, one that offers extremely attractive valuation for share buyback purposes. I expect the company to continue spending the majority of its free cash flow to repurchase stock for as long as this remains the case.

Finally, the company expects its book-to-bill ratio for the first quarter to be 0.95, with the full-year number to be slightly less than 1.0. Based on the company's expectation for future bookings, that means the company expects a further sales decline in 2013, albeit a very small one.

Lifted by jets
General Dynamics (NYSE: GD  ) , unlike L-3, managed to eke out a small increase over 2010 sales for 2011 at $32.7 billion. While General Dynamics has an impressive array of incumbent programs such as the Virginia-class submarine that provides it with most of its revenue, the biggest reason to be excited about this company is actually its aerospace segment, home to its Gulfstream business.

The company's aerospace sales were up $1.9 billion in the fourth quarter, up 50% YOY and 30% sequentially. In fact, aerospace was the reason for the company's modest sales increase over 2010. Its other three segments actually had $488 million less in sales in 2011 than in 2010. 

Looking at the aerospace segment's backlog, future sales growth seems imminent. After the company's strong fourth-quarter finish, Gulfstream booked the highest number of orders in 2011 since it introduced the G650 in 2008. This caused the backlog to further increase, to $17.9 billion. In fact, if a new customer were to order a Gulfstream G650 today, it would take until 2017 to receive the jet because of the massive 200-airplane backlog.

Also, in the much longer term, General Dynamics is excited because a larger installed base of business jets means more recurring-services revenue in the form of maintenance and spare parts. With increasing jet sales and corresponding service opportunities on the horizon, the company's aerospace segment has a bright future.

Looking forward, General Dynamics should expect strong Aerospace sales thanks to its burgeoning backlog. On the defense side as well, things look pretty good. The company estimates its defense revenue in 2012 to decline very modestly, only about 1% or 2%. A decline that small is actually a big plus given the difficult budget environment. Also, the company's rapidly growing aerospace segment should allow the company as a whole to see sales increase moderately yet again. Current analyst estimates call for a 1.8% increase in sales for 2012.  

Foolish bottom line
The defense-budget environment has hurt defense stocks across the board, since these companies are not expected to increase defense revenue again for a long time. However, the space certainly looks cheap because of the cheap valuation multiples combined with buybacks. I don't know when the defense environment will turn itself around, but L-3 and General Dynamics are interesting companies poised to benefit should the budget environment improve.

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Paul Chi is an analyst on the Fool's Alpha and Duke Street services. You can follow him on Twitter to stay up-to-date on his latest market commentary. Paul and Matt Argersinger co-manage the Street Fighter portfolio, where they look for cheap, unloved stocks with home run potential. Paul does not own shares in any companies mentioned.

The Motley Fool owns shares of L-3 Communications Holdings and General Dynamics. Motley Fool newsletter services have recommended buying shares of L-3 Communications Holdings. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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