What happened
The shares of Raytheon Company (RTN +0.00%), Lockheed Martin Corporation (LMT 0.02%), and Northrop Grumman Corporation (NOC +0.03%) were all trending steadily higher throughout the month of January. In fact, they were each up in the low single digits on Jan. 24. But by the time the month was over, they had all rocketed to low double-digit gains, with most of the advance taking place over just a few days. When January finally drew to a close, Lockheed was up 10.5%, Northrop had advanced just under 11%, and Raytheon led the group with a stock move of 11.2%, according to data provided by S&P Global Market Intelligence.
So what
The big story here was earnings related. On Jan. 25, Raytheon and Northrop both reported earnings that pleased investors. It wasn't so much the results from 2017, which were actually hampered by the tax code change, but the outlooks provided for the future. Essentially, the management teams of both companies are expecting a good year in 2018, at least partly because of a supportive administration in Washington, D.C.
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Lockheed Martin didn't report its results until a few days later, but its shares went up along with Raytheon's and Northrop's on investor hopes that its earnings would be a good read, too. They weren't disappointed, with Lockheed's Jan. 29 earnings release largely presenting a positive outlook for the new year.
Military-industrial peer General Dynamics Corporation (GD 0.22%) also got in on the act, with its share up around 9.4% in January. General Dynamics reported its earnings on Jan. 24. The company's update specifically noted strong demand on the military side of its business, leading to an increase in its backlog in that segment. In other words, there was widespread strength in the sector driven by strong business fundamentals.
Now what
At this point, investors are expecting solid years from General Dynamics, Lockheed, Raytheon, and Northrop in 2018. As you might expect, their stocks moved higher along with their positive earnings updates and outlooks. But that means that investors have already priced a lot of good news into the stocks.
LMT PE Ratio (TTM) data by YCharts
Here's the problem: Investors were already pricing in good news before the earnings updates. In fact, all four of these companies were already looking a little expensive relative to their own histories and the broader market in late 2017. While investors may view the current round of earnings and suggest those valuations are justified, a little caution may be in order.
It's worth looking at some numbers here. General Dynamics' five-year average P/E is around 17, but its forward P/E is nearly 20. Lockheed Martin's five-year average is 18.5, with a forward P/E of around 26. Northrop's average P/E is around 16.5 and its forward P/E is roughly 23. And for Raytheon, those numbers are 17 and 21, respectively. That's just one metric; the trend toward overvaluation shows up in price to book, price to sales, and price to cash flow, too. Their dividends are, uniformly, below their five-year averages as well.
That's not to suggest that 2018 will be worse than investors expect. The issue is the balance between price and value, and at this point all four of these government contractors look expensive. There's no question that the 2017 earnings releases here were good reading, but investors who care about valuation should think very carefully before jumping on this bandwagon.
