Better Buy: General Dynamics Corporation vs. Raytheon

Defense stocks could do no wrong in 2017, climbing steadily higher throughout the year, but investors in recent days have soured on the primes in the wake of first-quarter earnings that failed to live up to elevated expectations. General Dynamics (GD -0.29%) and Raytheon (RTN), two of the best-run companies in the industry, are down 5.91% and 7.44%, respectively, since April 24.

Even after the sell-off, the companies are still trading well above their historical norms. But despite the market's reactions to first-quarter results, the fundamentals remain solid, and both General Dynamics and Raytheon presented rosy future outlooks. Here's a look at the recent results and future prospects of both GD and Raytheon, with an eye on which is a better buy right now.

Data source: Yahoo! Finance. Data as of April 26, 2018. TTM = trailing 12 months.

Business jet blues

General Dynamics has been my top pick among defense primes, and although the first-quarter results didn't alter my optimism about the company, they might have pushed back the timetable. The company reported earnings per share that beat expectations, but its profit margin dropped to 13.4% form 14.1% a year prior. And its aerospace unit saw revenue drop by 12% due to delivery weakness at its Gulfstream business jet unit.

The forthcoming Gulfstream G500 business jet. Image source: General Dynamics.

General Dynamics' core defense business continues to fire on all cylinders, growing revenue by 6.4% in the quarter, and the company was among the winners of the fiscal 2019 budget request with a potential appropriation 30% higher than its fiscal 2017 result. The company is also beginning to integrate its $9.6 billion acquisition of CSRA, giving it added exposure to the government IT sector in a year when federal demand for IT services is expected to surge.

Gulfstream has been both a headwind for General Dynamics in recent years and a reason for hope going into 2018. The business jet sector to date has not yet recovered from the 2008-2009 recession, but Gulfstream reported net orders up 20% year over year in the fourth quarter, and management in January expressed confidence that the worst was over for the unit.

General Dynamics reported a book-to-bill ratio for its aerospace unit of 0.77 in the quarter, down from 1.3 in the fourth quarter of 2017. The first quarter is typically the weakest of the year, but General Dynamics indicated that initial deliveries of the highly anticipated G500 midsized business jet will not occur until the final four months of 2018, missing the targeted second-quarter introduction.

Signs continue to point to a bottoming out of the business jet sector, but with the G500 delayed and the larger G600 lagging behind the 500, a real Gulfstream ramp might not happen until 2019. If so, General Dynamics' 25% valuation discount to its rivals might not close as quickly as I had hoped.

Missile master

Raytheon delivered first-quarter earnings of $2.20 per share, ahead of the $2.11 consensus estimate, and it raised its full-year profit forecast by $0.15 per share, but about two-thirds of that increase was attributable to changes in the U.S. tax law. And although Raytheon did raise its full-year net sales estimate as well, the company did not boost its forecast for operating cash flow.

A Patriot missile launch. Image source: Raytheon.

Though the quarter seemed to disappoint investors, there is plenty in the forecast to suggest growth on the horizon. Raytheon owns a commanding presence in precision weapons, anti-missile systems, and sensors and radars, all areas of interest to the Pentagon. It is also the most diverse U.S. prime contractor in terms of international sales, with about 42% of its backlog comprised of international programs.

Raytheon's Patriot missile systems are deployed in the Middle East and a growing number of European countries, and missiles are the source of much of the more than $15 billion in potential additional international revenue that Raytheon could book before the end of 2019. The company also makes a small-diameter bomb that's deployed on Lockheed Martin's F-35 joint strike fighter, opening new sales opportunities for Raytheon in every market where the F-35 is deployed.

Raytheon figures to be one of the big winners from a Trump administration overhaul of U.S. arms export policies aimed at expanding weapons sales to allies. The White House has argued that increasing military exports to friendly countries will help the Pentagon to coordinate operations with allies while boosting jobs at home. Raytheon CEO Thomas A. Kennedy on a call with analysts called the effort "extremely helpful" in supporting the company's international outreach.

At home, the Pentagon has placed an emphasis on replenishing U.S. missile stocks, increasing spending on Raytheon missile programs by about 20% in the 2018 budget. Those sales are still making their way through the procurement process, but Raytheon expects a "significant uptick" in munitions deliveries beginning in 2019 and lasting into 2021.

I'm sticking with General Dynamics

If there is one thing we learned from the post-earnings sell-offs in defense companies, it is that Wall Street is no longer excited by companies trading at sky-high valuations delivering results that are fine but not exceptional. Thanks to increased missile and IT spending, and in GD's case, the potential for a business jet sales uptick, both companies have the potential to deliver the growth investors demand in the quarters to come.

Raytheon with its missiles programs seems the surer bet to deliver on that upside, but the company also trades at a premium to General Dynamics. Though a Gulfstream recovery might not come as quickly as I had hoped, I still believe it is coming, and as results at the unit improve, shares of General Dynamics are likely to close the valuation gap that currently exists between it and Raytheon.

These are two great companies, but for the long term, General Dynamics remains the better buy.