Better Buy: Lockheed Martin vs. Raytheon Technologies

The defense sector hadn't seen a megamerger since the 1990s, but that all changed last month when the aerospace arm of United Technologies combined with Raytheon to form Raytheon Technologies. The deal vaulted the new company above industry leader Lockheed Martin in terms of revenue, creating a new heavyweight in the aerospace world.

Lockheed Martin stock in recent years has been a standout performer among defense primes, and bigger does not always mean better. But is Lockheed Martin still a top buy, or has Raytheon Technologies surpassed it in terms of investor interest as well? Here's a look at the two companies and some facts about them that can help determine which is a better buy today.

Source: Yahoo! Finance, data as of May 7, 2020, closing prices.

Lockheed Martin: The defense heavyweight

Lockheed Martin remains the world's largest pure-play defense company, with an arsenal full of products vital to many nations' security. The company is best known as the maker of the F-35 Joint Strike Fighter, a potential trillion-dollar program for the company and its key suppliers. Its portfolio also includes missiles, missile defense systems (including the THAAD units deployed against threats from North Korea and elsewhere), and a range of other defense products.

The business has performed well in recent years, with the company expected to produce about $6 billion in free cash flow this year. The F-35 has still not yet hit full-rate production, and the jet almost certain to generate substantial revenue annually for the rest of the decade. Meanwhile, Lockheed Martin has also established itself as a leader in hypersonics, missiles that travel more than five times the speed of sound, an emerging area of concern that the Pentagon is committed to investing in.

Image source: Lockheed Martin.

The company on April 21 reported first-quarter revenue and earnings that came in ahead of expectations and said that although the pandemic was slowing some supply deliveries, the business is holding up well overall. Lockheed Martin also ended the quarter with an order backlog of $144 billion, providing ample fuel for future earnings.

Heading into 2020, there were concerns that after years of growth, the Pentagon's budget was near a cyclical peak, and with the U.S. government committed to spending at least $3 trillion on the pandemic response, it's possible the Defense Department could be pressured to cut its budget in the months to come.

That is a potential drag on industry growth that investors should monitor carefully, but there are plenty of Pentagon priorities contained within Lockheed Martin's product list to keep the business going strong even if there are cuts.

Raytheon Technologies: New to the battlefield

Raytheon Technologies was formed on April 3 when United Technologies completed a deal to combine its aerospace assets with defense contractor Raytheon. The transaction created a defense and commercial aerospace powerhouse, combining Raytheon's missile, sensors, and specialized electronics with United Technologies' Pratt & Whitney engines and Collins aircraft interiors.

The deal was initially criticized by investors in both companies, including some high-profile activists who held United Technologies shares, who balked at the idea of watering down the two pure-play businesses with exposure to each other.

Today, it appears the Raytheon shareholders got the worse end of the bargain. United Technologies' business relied on commercial aerospace, a high-flying industry prior to the COVID-19 pandemic that is now under extreme pressure. Airlines that just a few months ago were in growth mode are now focused on survival, grounding huge segments of their fleets, and deferring new plane orders.

Image source: Raytheon Technologies.

On May 7, the new Raytheon Technologies held its first combined earnings call, at which time it announced plans to cut about $2 billion in costs and take other actions to conserve about $4 billion in cash on the commercial aerospace side. "It's going to be a full two years before we see a recovery" to 2019 levels, if not longer, CEO Greg Hayes predicted.

Fortunately, the defense side of the business provided a solid backstop. Raytheon's new orders came in at 1.44 times what went out the door, which caused it to end the quarter with a $50 billion backlog to go alongside United Technologies' $20 billion defense backlog. The post-merger company last month got its first high-profile defense win when it was awarded a contract to develop a new Long-Range Standoff Weapon, beating Lockheed Martin for the prize.

Expect the two companies to battle it out over other defense contracts for years to come as Lockheed Martin and Raytheon are two of the top contractors when it comes to missiles and missile defense.

In selling the merger to Wall Street over the past few months, Hayes often emphasized the "balance" it created. His thesis was that bringing together a cyclical commercial business and a cyclical defense business meant that the combined company would be better able to weather the downturns in those different cycles. Given what's happened to the commercial business due to the pandemic, we are going to get to test that theory much sooner than either company imagined heading into the deal.

And the better buy is...

These are two good companies with strong sets of assets and solid management, so I would feel comfortable holding either stock for the long-haul. Lockheed Martin has a diverse defense business with exposure to a number of top Pentagon priorities, while Raytheon Technologies should be able to manage through the coming commercial aerospace downturn better than more-concentrated suppliers can, and should benefit from that balance Hayes spoke of over time. Raytheon also has the higher dividend yield, at least for now, and Hayes said the company remains committed to continuing its payouts despite its pandemic woes.

I wouldn't sell either stock to buy the other, and I expect both companies to be winners over time. But for new money being invested today, Lockheed Martin is the better bet. The company should be able to generate growth even if the Pentagon budget comes under pressure thanks to the backlog of new orders already on its books, and management in recent years has had the business firing on all cylinders.

Raytheon Technologies is a survivor, but given the challenges of integrating two complex organizations, I'm hesitant to buy into megamergers even in the best of times. Add in the complexity of managing an integration during a pandemic and the pressure its commercial business will be under for the foreseeable future, plus that same risk of Pentagon belt-tightening, and it's obvious why I'm concerned that Raytheon Technologies won't be thrilling investors for awhile.