Should You Buy Lockheed Martin Stock, or Its New Rivals?

Lockheed Martin (LMT 0.38%) is huge in Japan -- and in the United Kingdom, too.

Second (and third) only to the United States, the Japanese and British militaries are the two biggest buyers of Lockheed Martin's fifth-generation stealth fighter jet, the F-35 Lightning II. So it came as something of a surprise this summer when Japan and Britain announced that they were teaming up to build their own stealth fighter jet to compete with the F-35.

Military history

As Reuters reported at the time, rather than partner with Lockheed Martin, Japan's Mitsubishi Heavy Industries (MHVYF 3.40%) and Britain's BAE Systems (BAES.Y 1.33%) now plan to build their own sixth-generation fighter together and cut Lockheed Martin out of the deal.

Turns out, this is a pretty popular idea, too. Earlier this month, The Wall Street Journal reported that Italy's Leonardo DRS (DRS 0.28%) wants to get into the new consortium, which the companies are calling the Global Combat Air Program, or GCAP. Additional companies including Japan's IHI, Britain's Rolls-Royce Holdings (RYCEY 1.02%), Airbus (EADSY 0.97%) subsidiary MBDA, and General Electric's (GE -0.69%) Italian subsidiary Avio Aero will build the fighter's jet engines.  

(So one way or another, U.S. companies will still get a piece of this action).

The Global Combat Air Program is aiming to have a prototype ready to begin test flights in 2027, and to begin deploying the new plane in 2035.

A plethora of options

The trio of Japan, Britain, and Italy is just one of at least three groups now developing next-generation fighters. In Europe, France's Dassault, Spain's Indra, and Germany in the form of Airbus have allied to invest more than $100 billion in a variant called the Future Combat Aircraft System, or SCAF. And of course, Lockheed Martin itself hopes to build a next-generation air dominance (NGAD) fighter for the U.S. military.  

For today, let's focus just on the two most obvious investing possibilities -- and examine which one holds the most potential.

Lockheed Martin or ...

Lockheed Martin is, of course, the most familiar option and the easiest for U.S. investors to examine.

Valued at $126.7 billion, Lockheed Martin stock sports a price-to-earnings ratio of 21.5 (about 7.5% more expensive than the average S&P 500 stock), a dividend that yields 2.5% at the current share price, a long-term expected annualized earnings growth rate of 6.5%, and therefore a total return ratio of 2.4.

That's not cheap. On the other hand, the combined fourth-generation fighter forces of Italy, Japan, and the U.K. amount to fewer than 500 planes that the GCAP might replace. Whereas in the U.S., an NGAD fighter would presumably be used to replace nearly 1,100 fourth-generation F-15s and F-16s. That gives Lockheed Martin a domestic market that's more than twice as big as the combined markets of Italy, Japan, and the U.K. -- before even considering its opportunities for international sales.  

This gives Lockheed Martin the potential to spread its NGAD development costs across more planes, lowering per-plane costs, making the plane cheaper and likely more popular when sold internationally, and thereby probably boosting profit margins (assuming it wins the Pentagon's NGAD contract, of course).

... Lockheed Martin's rivals

So Lockheed Martin stock costs a lot, but has a bigger potential market. But how much more does Lockheed Martin cost than its rival defense stocks, and does the potential justify that difference in valuation?

BAE Systems -- probably the most familiar name in the GCAP coalition for American investors -- sells for just under 20 times earnings. That's a similar valuation to Lockheed's. BAE sports a superior dividend yield (3%) and faster growth estimates (10%). But I don't think the advantages of BAE's stock clearly outweigh Lockheed's advantages as a company.

Similarly, Leonardo DRS looks cheaper than Lockheed Martin at an apparent price-to-earnings ratio of 8.6. However, that company was formed out of a recent merger between Italian and Israeli defense corporations, and I'll be leery about relying on the accuracy of its financial data until it's filed a few quarterly reports. Although it could be a bargain stock, for the time being, I'm still inclined to prefer Lockheed Martin over DRS.

In contrast, Mitsubishi Heavy Industries, the likely leader of the Japan-Italy-U.K. coalition, trades at a cheap 11 times trailing earnings. Analysts polled by S&P Global Market Intelligence estimate Mitsubishi will grow earnings at a robust 16.6% annually over the next five years, and its dividend yields a modest 2.3% to boot. That gives Mitsubishi a total return ratio of just 0.6 -- clearly superior to Lockheed's valuation. And Mitsubishi should benefit from surging defense spending in Japan.  

Granted, Mitsubishi also carries a boatload of debt -- $6.5 billion net of cash on hand. But even factoring debt into the picture, Mitsubishi looks very cheap at less than half the valuation of Lockheed Martin.

If you're optimistic about the future market for sixth-generation fighter jets, and looking for an alternative to Lockheed Martin to invest in, Mitsubishi Heavy looks like your best bet.