"[W]e haven't necessarily found [any defense companies to buy] that we found to be compelling either from a price expectation perspective or from a fit and rationale perspective."
-- General Dynamics CFO Jason Aiken

For months I've been saying that defense stocks in general have gotten too expensive. General Dynamics (GD -0.25%) seems to agree with me, and now Wall Street does, too -- at least in part. Yesterday, investment megabanker Morgan Stanley initiated coverage of the defense sector, assigning new ratings to four of the nation's biggest defense contractors.

The big surprise? Last month, I argued that at today's high valuations, the only two defense stocks I'd even consider putting new money into today are Raytheon (RTN) and Lockheed Martin (LMT -0.05%). And would you care to guess which companies are Morgan Stanley's two top picks in the defense industry?

Yep, Raytheon and Lockheed Martin. Here's what you need to know.

F-35 fighter jet

What's one defense stock that Morgan Stanley likes? Here's a hint. Image source: Getty Images.

Morgan Stanley's sole sell

Let's start at the bottom with General Dynamics, Morgan Stanley's least favorite stock in the defense space. Initiating coverage of General Dynamics with an underweight rating and a $185 price target, Morgan Stanley predicts that General Dynamics stock will lose 6% of its value over the next 12 months. Admittedly, General Dynamics' 1.7% dividend yield should soften the blow. But still -- investors buy stocks in the hopes that they will go up, not down. That's not the way Morgan thinks this story will play out, however.

What doesn't the banker like about General Dynamics? Two things:

First, Morgan Stanley doesn't see President Trump delivering on his promise to spend more money on the military -- and the U.S. Navy in particular. Unfortunately, data from S&P Global Market Intelligence show that "marine systems" accounts for more than a quarter of the revenue General Dynamics depends on in a year. Thus, bad news for naval shipbuilding contracts is bad news for General Dynamics.

Granted, aerospace is also a big business for General D. Gulfstream jets account for barely 25% of General Dynamics' revenue, but nearly 40% of its profits. That's both a blessing and a curse, though, because Gulfstream's sky-high profit margins -- twice what rivals Bombardier, Dassault, and Textron earn -- are starting to attract competition. General Dynamics may struggle to maintain the fat profit margins that produce those profits "given competitive threats" from rival business-jet builders.

Northrop grumblin' about cash

Turning next to Northrop Grumman (NOC 0.16%), Morgan Stanley assigns this one an "equalweight" rating (i.e., hold) and a $279 price target, suggesting minimal upside. In the analyst's opinion, Northrop Grumman's "light free cash flow yields and margin growth" disqualify the stock from receiving a buy rating.

I've highlighted Northrop's margin issues myself -- and not so long ago -- so I won't rehash that complaint here. As far as the company's free cash flow goes, it...really doesn't go very far. Over the past 12 months, Northrop reported earning GAAP profits of $2.3 billion, which was up modestly from last year's full-year results. Unfortunately, S&P Global data confirm that with Northrop generating less than $1.5 billion in free cash flow during the period, the company is generating only about $0.63 in real cash profit for every $1 it claims to be earning.

Raytheon rising

And now it's time for some happier news. Despite the exceptions noted above, and despite some misgivings about how much defense stocks have already run up, Morgan Stanley is still broadly optimistic about the defense industry "given headlines around North Korea, Russia, the Mideast" and generally "expanding" defense budgets. One of the two stocks Morgan still sees as having room to run is Raytheon.

Praising the company's expertise in missile defense, its broad international exposure, and its decision to invest in cybersecurity, Morgan Stanley says Raytheon is "positioned for solid revenue growth and upside surprises" in the years to come, according to StreetInsider.com (requires subscription). Even more than the business opportunities, though, the analyst just loves Raytheon's balance sheet, which it describes as "A-rated."

Morgan Stanley gives Raytheon an overweight rating and predicts its stock -- below $179 today -- will rise past $188 within a year.

Lockheed Martin: Finally ready to fly?

The single defense stock that Morgan Stanley likes best, though, is Lockheed Martin -- and it's not hard to see why. Over the past year, Lockheed Martin stock has gained only 16%, which is a smaller gain than any of the other big defense contractors have enjoyed, and indeed, only slightly better than the average stock on the S&P 500.

But the thing is, Lockheed Martin stock is a lot better than average -- which is why Morgan Stanley recommends buying it. As Lockheed Martin spins up its F-35 fighter jet manufacturing machine -- a business likely to thrive over the next five to six decades -- Morgan Stanley praises the company's "robust segment margin growth ... [and] multi-decade revenue visibility." At the same time, while some have criticized Lockheed's decision to acquire low-margin Sikorsky from United Technologies a couple years back, Morgan Stanley believes that there's a lot of "growth potential in helicopters" that Lockheed has yet to capitalize upon.

Between these two businesses, and certain Lockheed "missile-related solutions" besides, Morgan Stanley predicts that Lockheed Martin will enjoy an industry leading "5-year EPS CAGR of ~15%." Admittedly, that's nearly triple the rate of earnings growth that the rest of Wall Street expects to see, and therefore something of an outlier. But consider: Lockheed Martin stock sells for just 17.4 times earnings today. Lockheed's 17.4 P/E, weighed against 15% growth and a 2.5% dividend, would value Lockheed Martin stock at just under the magical 1.0 PEG ratio...

...and make Lockheed Martin stock a buy.