Comparing commercial aerospace giant GE Aerospace (GE +1.57%) with leading defense contractor Lockheed Martin (LMT 0.77%) is always interesting because it requires taking a big-picture view. This isn't about one quarter's earnings or even a year's worth; it concerns a long-term view of how each company makes money. So let's dive in and see what we can find out.
The better stock
Spoiler alert: GE Aerospace, which makes aircraft engines, is the better stock. While not everyone will agree with that conclusion, the debate will shed some light on the long-term investment cases for each stock.
GE Aerospace operates in the commercial aviation industry, an indispensable part of the global economy. While airlines haven't always been such great investments, and the industry has suffered periodic cyclical highs and lows, airlines have traditionally not had an issue raising debt (not least because debts are securitized with valuable assets, the planes themselves).
Plus, there's no way to avoid air travel if you want to travel quickly over large distances.
NYSE: GE
Key Data Points
GE Aerospace's market position
As such, GE Aerospace operates in an industry with only two truly global airplane manufacturers, Boeing and Airbus. That means it has a high level of certainty over its developmental programs. At the same time, there are numerous end-market customers, including the airlines themselves. As noted above, even if some airlines fail, there are usually others coming along backed up by bondholders.
With engines on both major narrowbody airplanes -- the Boeing 737 MAX and the Airbus A320 neo family (RTX also offers an engine on these planes) -- GE Aerospace is ideally placed to generate lucrative aftermarket revenue from its installed base of engines for many decades to come.
Aircraft engines can last for over 40 years and generate parts and services revenue over that cycle as they are overhauled and repaired. This adds up to a highly favorable set of end market conditions, where GE Aerospace has a high degree of certainty over the development of its engines (mainly sold into Boeing and Airbus programs) and a high degree of certainty of its end market due to its ability to diversify and reduce risk by selling engines to many different airlines.
NYSE: LMT
Key Data Points
Lockheed Martin: This time, it's not the same
For investors who don't believe in coincidences, there's much to consider regarding major defense contractors. Boeing's defense business keeps generating losses, notably on fixed-price development programs. Meanwhile, RTX's defense business also keeps struggling with profit margins and recently took a charge on the termination of a fixed-price development program in its defense business. RTX also reduced its overall free-cash-flow guidance in 2024 due to the issue.
The bulls' case for Lockheed Martin
Turning back to Lockheed Martin, the defense contractor has also had margin issues in recent years. Management believes that 2024 will be a low-water mark for margins, and according to CFO Jesus Malave on the last earnings call, the company expects margins "to improve gradually over the next few years."
Recent struggles with defense company margins challenge the investment narrative around defense stocks. Investors like defense stocks because they are seen as being in a relatively stable industry with solid growth prospects and low-end market risk since their customers are sovereign governments.
Image source: Getty Images.
Defense company bulls will argue that the recent margin pressures focus on fixed-price development programs procured in less inflationary times. Moreover, defense companies have been uniquely hit with supply chain issues, raw material price increases, and product availability issues (for example, rocket motors or titanium castings).
The bulls argue that margins will improve once these issues abate and Lockheed Martin and others work through the fixed-price programs.
The bears' case for Lockheed Martin
The other side of the argument notes that margin deterioration appeared to be in place before anyone had heard of the pandemic. Moreover, many other industrial companies have overcome supply chain difficulties and raw material prices, but the defense industry is finding it a lot harder to do -- suggesting this may be a structural, rather than temporary, issue.
LMT Gross Profit Margin data by YCharts
Moreover, with seemingly ever-rising levels of sovereign government indebtedness, there's a tangible movement toward forcing fixed-price programs on defense contractors. That's a real concern as it suggests the industry needs to prepare itself for structurally lower margins over the long term.
GE Aerospace vs. Lockheed Martin
All told, investors have cause for concern until the question of structural profit margins is resolved in the defense industry. Despite the cyclical risk in the commercial aerospace industry, GE Aerospace is the better buy as its long-term earnings growth trajectory looks more secure.
