Better Buy: Raytheon Company vs. General Dynamics

Following a steady run up after the November 2016 presidential election, defense stocks appear to be at a crossroads. The companies, fueled by expectations of increased defense spending, are trading well above historical valuations. But then again the world seemingly is growing more dangerous by the day, providing little evidence that demand for armaments will soon subside.

In this market, investors must choose carefully when putting new money to work. Here's a look at the prospects for Raytheon (RTN +0.00%) and General Dynamics (GD +0.45%), with an eye on which is the better buy right now.

Data source: Yahoo! Finance, data as of March 13, 2018. TTM = Trailing 12 month

Electronics specialist in a digital age

Raytheon, up more than 50% since November 2016, is perhaps the best positioned of any defense contractor. The company has a commanding presence in precision weapons, anti-missile systems, electronics warfare systems, and sensors and radars -- all areas of particular interest to the Pentagon as it plots spending priorities.

Illustration of a Raytheon SM-3 interceptor launch. Image source: Raytheon

Raytheon's Patriot missile systems are the first line of defense in the Middle East and growing in popularity elsewhere. Its radars and sensors are used on platforms manufactured by defense rivals including Lockheed Martin's THAAD anti-ballistic system aimed at countering North Korean threats.

The company is also more diversified than some of its peers. Raytheon books about one-third of total sales outside of the United States, the best among defense primes, thanks to strong interest in the Patriot and the expertise of its radars. It also has a large cybersecurity unit, Forcepoint, which it hopes to grow with government and commercial customers. To date, Forcepoint has failed to live up to expectations, but the company continues to rework operations in hopes of creating a winner in what is a rapidly expanding field.

Raytheon ended 2017 with a $38.2 billion backlog, up 4% from a year prior, and in January predicted it will grow cash from operations by more than 40% in 2018, including the benefit of tax reform. In November, the board authorized a new $2 billion share buyback on top of the $900 million available at the time under a 2015 program, continuing a trend that has seen it reduce its share count by about 30%. A dividend hike could be announced any day now, in keeping with what has become an annual tradition for the company.

Dynamic General

While Raytheon has been among the best stock performers since the election, General Dynamics has been a laggard until recently. The company posted a full-year 2017 stock gain of "only" 17.83%, weighed down by a commercial business stuck in the doldrums and perception that its military operations were not as aligned with Pentagon needs as others.

There is growing evidence that those headwinds are fading. The company's Gulfstream unit, a business jet operation that has still not fully recovered from the 2008 recession, reported fourth-quarter net orders up 20% year over year, with large cabin orders up almost 30%. Its mainstay G650 saw orders grow 78% year over year, the second-best quarter for the jet since its launch in 2008.

Changes in the tax law for 2018 should help new business jet sales, speeding depreciation. General Dynamics officials indicated several orders were moved from late 2017 into 2018 perhaps in anticipation of tax changes.

On the defense side, General Dynamics was a surprise winner from the Pentagon's fiscal year 2019 budget request with a potential appropriation about 30% higher than its fiscal 2017 result. Its shipyards should stay busy with new submarine contracts, and funding to purchase its Abrams tanks was increased. Overall Cowen analysts believe General Dynamics could boost defense sales more than 5% in 2018, and another 6% or more in 2019.

A General Dynamics M1 Abrams tank in action. Image source: General Dynamics.

In February, General Dynamics committed $9.6 billion to acquire CSRA to boost its government IT offerings. While many of its defense prime rivals have been moving the other direction and shedding IT businesses, General Dynamics believes that by creating the second largest government IT contractor the merged unit will have the scale needed to compete more efficiently. The company expects to generate about $200 million in annual savings from the deal.

General Dynamics CEO Phebe Novakovic earlier this year told investors that growth at her company's internal IT arm was slowed in 2017 because of the impact of short-term government funding resolutions and delays related to the transition to a new administration. She said the unit's backlog remained healthy, and business began to pick up in the second half of the year, which she said, "leads me to be confident that the growth in this business will materialize beginning in 2018."

The General outranks them all

In a richly valued sector, General Dynamics stands out as the best pick for new investment. The company still trades at a discount to Raytheon and other rivals. Given the potential upside from increased business jet demand and new IT contracts, it's quite possible 2018 is the year that General Dynamics closes that valuation gap.

Raytheon is a strong company and will likely perform well in the years to come, but General Dynamics is the better buy right now.