3 Top Defense Stocks to Consider Buying Now

It has been a fantastic year for defense stocks, as the promise of a post-election pickup in Pentagon spending coupled with increasing threats from North Korea and elsewhere has caused investors to bid up shares, in some cases, by as much as 30% year to date. It's tough to find value in the sector today, but investors with a long-term horizon could still benefit from buying into General Dynamics (GD 1.17%), Huntington Ingalls Industries (HII 1.05%), and Leidos Holdings (LDOS 0.93%).

The logic behind the rally was sound, with the Trump administration and Congress in agreement over the need to refresh a range of key Pentagon weapons systems -- which should bring billions to the coffers of companies like GD, Huntington, Lockheed Martin (LMT 1.71%), Northrop Grumman (NOC 2.23%), Raytheon (RTN), and L3 Technologies, while also benefiting government services firms including Leidos, ManTech International, and CACI International.

A Lockheed Martin Terminal High Altitude Area Defense (THAAD) launch. Image source: Lockheed Martin.

But given the slow and plodding nature of defense work, and the government's habit of falling behind on procurement, there's a danger the stocks have gotten ahead of themselves. Five years ago no major defense firm traded above a price-to-sales ratio of 1; now some hover around 2 times sales. And price-to-earnings multiples are at near-record highs.

An argument can be made that the lows of earlier in the decade were more the anomaly than the current valuations and that the current prices are more of a new normal than a bubble. The United States is, and figures to remain, a great market to sell weaponry -- annually spending more on defense than its five closest rivals combined. And a post-Cold War round of consolidation in the sector created a handful of multifaceted companies that are set up to be less reliant on winning a single program competition.

Data source: Yahoo! Finance. P/E = price-to-earnings; P/S = price-to-sales; TTM = trailing-12-month.

Even assuming this is a new normal, it's hard to be too excited right now, given how far valuations would have to stretch to provide further upside from these levels. That said, defense is an important slice of the economy that is hard to ignore. Here are three stocks worth looking at as you search for upside.

Commercial opportunities

General Dynamics, though far from cheap, is priced at a discount to rivals Northrop and Raytheon. In part this is because unlike those two defense-focused companies, GD also owns business-jet maker Gulfstream, a unit (and an industry) that was hit hard by the 2009 recession and has been slow to recover. Gulfstream shipped 115 business jets worldwide in 2016, according to the General Aviation Manufacturers Association, down from 156 in 2008.

It's far too early to predict a return to pre-recession levels, but there is evidence that if nothing else a bottom has formed: Through the first nine months of this year, worldwide business-jet deliveries are up 1.4%. A stabilization in business jets could, if nothing else, diminish the discount the market is applying to General Dynamics shares, boosting its valuation.

Gulfstream could provide some unexpected upside for General Dynamics. Image source: General Dynamics.

General Dynamics has other things going for it as well. The company has a pristine balance sheet with net debt of just $2.2 billion at the end of the third quarter, giving it the sector's best debt-to-equity ratio. On the third quarter conference call, CFO Jason W. Aiken said that GD sees its balance sheet "as an opportunity for when and if strategic opportunities come up, that we are ready to be agile and move quickly with those opportunities."

If nothing else, absent a massive debt load, General Dynamics is free to spend its cash on shareholders. Through the first nine months it has spent nearly $1.9 billion, or nearly 120% of free cash flow, on repurchases and dividends, while still making a number of small acquisitions.

A safe harbor

Huntington Ingalls is the rare non-diversified defense prime contractor, but the shipbuilder does own massive shipyards in Virginia and Mississippi and stands out as the nation's sole builder and refueler of nuclear-powered aircraft carriers. It competes with General Dynamics on other shipbuilding duties, but the U.S. Navy appears poised for an upgrade that should be a rising tide for all participants.

Last year then-candidate Donald Trump ran on a promise to boost the current 275-ship Naval fleet to 350 vessels. Such a massive jump seems unlikely, but Huntington's $23 billion backlog is a sign that the Navy is in a period of renewal.

In the third quarter, Huntington showed how profitable its core business can be; it posted earnings per share 17% ahead of consensus, thanks to margins that came in better than expected. Some of that margin beat was nonrecurring in nature, having to do more with risk retirement and other one-offs instead of a more efficient operation, but the company is lobbying the Pentagon to make multiship orders in the future to help drive down manufacturing and part sourcing costs.

The company has offered very conservative guidance, saying it expects revenue to be flat through at least 2020. But Huntington Ingalls also does not bake any repair revenue into its long-term forecasts because such contracts are hard to predict. Huntington has already won some high-profile repair work, including upwards of $500 million to repair the USS Fitzgerald Arleigh Burke-class destroyer, and generally has more excess capacity at its shipyards than General Dynamics does.

Add in that the Navy has made maintenance and repairs of its existing fleet a priority, raising its operating and maintenance budget request to $51.3 billion for 2018 compared to $46.9 billion in 2016, and there is a decent chance that top-line growth at Huntington Ingalls will exceed modest expectations.

Beltway bandit

Leidos, formed from the 2016 merger between part of Science Applications International Corporation and the IT business of Lockheed Martin, provides system engineering, IT, and integration services for defense, intelligence, and civil agencies.

Coming out of the Cold War, government IT was seen as the next big growth business for the sector. But that view caused a rush of new entrants, who in turn lowered margins and created a shortage of capable (and cleared) employees. In the current market, economies of scale are massively important, and the deal that created Leidos provided that scale.

At the end of the third quarter the company reported a backlog of more than $17 billion and said it expects its margins for the year to be better than previously expected, thanks to contract wins and cost reductions. The company said it received $3.1 billion in new contract bookings in the quarter, with about 85% of that total being new business.

Those figures back up the justification company officials used to talk up the deal, and are a sign things are on track. Leidos also has contracts in place to support troops deployed in the field, and would theoretically stand to benefit from any Trump administration overseas deployments or readiness efforts.

Leidos started out with a considerable amount of debt, but in the third quarter used cash from operations to reduce its debt ratio down to its target of 3 times EBITDA (earnings before interest, taxes, depreciation, and amortization), a quarter ahead of schedule. The company said that with that target reached, it will now have more flexibility to do "meaningful" share repurchases, or additional mergers and acquisitions.

Managing increasingly complex IT systems and providing other services to the government is a steady and growing business, and Leidos now has the bulk to be one of the leaders in the field.