It hasn't been a great year for defense stocks. The likes of the RTX (RTX -0.29%), General Dynamics (GD -0.17%), and Lockheed Martin (LMT -0.75%) are all in negative territory in 2023, and the defense businesses of General Electric (GE 0.68%) and Boeing (BA 0.25%) have both had significant issues this year. What's wrong with the sector, and how should investors look at investing in it? Here's the lowdown.
A challenging year for the defense sector
The chart below shows the performance of the stocks mentioned above. General Electric is the only one that's outperformed the S&P 500 index, mainly because its defense business only represented around 7.6% of its revenue in the year's first half -- GE's operational outperformance has come from other areas of its business.
Data source: YCharts
What's going wrong
There are individual company issues that have hurt the stocks on the list. For example, I'm thinking of the manufacturing quality issues on fuselages that threaten Boeing's ability to hit its target for 400-450 deliveries of 737 MAX airplanes this year. RTX's major problem at the moment comes from the need to remove and inspect hundreds of its Pratt & Whitney geared turbofan (GTF) engines due to potential contamination in powder coating used to manufacture turbine discs in them.
That said, all of these companies are saying the same thing about their defense businesses, which can be summed up as follows:
- End market demand remains strong, and orders and backlog are in great shape.
- Supply chain and labor issues have extended longer than expected in 2023, putting pressure on margins and the ability to deliver on backlogs.
As such, investors have heard a common refrain from these companies this year. Supply chains persist, and there's pressure on margins and earnings expectations.
Image source: Getty Images. Supply chain issues have dogged the defense industry this year.
The supply chain remains an issue
GE Chief Executive Officer Larry Culp outlined the issues for the industry on the company's second-quarter earnings call: "Demand is not our fundamental challenge in the defense arena; throughput is. And the supply chain challenges that we've talked about and everyone talks about certainly applied to defense."
While defense is a relatively small part of GE's business, it's typically around half of RTX's. This year, the company's defense business progress typifies the industry's puts and takes. Management reported "lower productivity than we expected in the first half of the year, including costs associated with fixed price development programs," according to Chief Financial Officer Neil Mitchill on the second-quarter earnings call.
It's a similar story at Boeing, where CFO Brian West recently told investors about "new pressure" on its problematic fixed-price programs that previously caused multibillion-dollar charges for the company. Meanwhile, other legacy programs are taking longer to get back on track. As such, West expects Boeing's defense, space, and security profit margin to be negative in the third quarter.
Image source: Getty Images.
The issues are not only causing margin pressures, but they are also impacting defense companies' ability to deliver products. For example, RTX's CEO Greg Hayes has described obtaining rocket motors as "a bane of my existence" that has hurt the company's ability to deliver missiles. It's a similar story at Lockheed Martin, where production targets for missiles and rocket launchers have been pushed out from 2024 to 2026.
The glass-half-full view
The supply chain issues have caused unexpected problems this year, and they've disappointed investors who thought the sector would do well in the current environment of heightened geopolitical tension.
That said, it's important to keep a clear head, and there are two reasons it could be time to look at investing in the sector. The first is that orders and backlog remain in excellent shape. The chart below shows the second-quarter book-to-bill (booked orders received versus shipped) ratios for some companies discussed above. Moreover, the backlogs at General Dynamics ($91.4 billion) and Lockheed Martin ($158 billion) represent record figures. RTX also reported a record backlog in the second quarter of $185 billion, including $73 billion in defense.
Data source: Company presentations. Chart by author.
Second, while the improvement in the supply chain hasn't been as good as most expected, it is improving. One measure RTX uses to monitor the situation is its kit fill rates in its defense business. It's a measure of when all the parts of the kit are on the shop floor to assemble -- a figure of 100% means all the kit is there 100% of the time.
RTX aims for a kit fill rate of 90%-95%, but in July 2022 it was just 50%. At the time, Hayes said he expected the rate to rise to 80% by the end of 2023. Fast-forward to July 2023 and that rate is now up in the mid-70s.
It's an improvement, even if it's significantly slower than management expected.
A sector to buy into?
All told, the correction in defense stocks represents the market pricing and supply chain difficulties this year. Still, orders and backlogs are improving, and supply conditions will surely ease, leading to margin expansion and improved ability to deliver on backlogs. As such, the defense sector is one value investors should consider buying into.
