Defense Spending Booms -- Underwater and in Britain

It's been a rough couple of weeks for U.S. defense contractors, in the military shipbuilding space in particular.

On Jan. 29, General Dynamics (GD -0.20%) beat earnings forecasts (which had been recently lowered) with some help from its Gulfstream aircraft division, but disappointed investors by reporting weak margins in in its marine systems segment (General Dynamics' biggest division by revenue, according to data from S&P Global Market Intelligence).

One week later, it was Huntington Ingalls Industries' (HII -0.36%) turn to disappoint. A specialist in military shipbuilding, HII reported that both its sales and its earnings were less than Wall Street had hoped for. And operating profits at both the company's shipbuilding units (Ingalls and Newport News) declined year over year.

For the past several months, I've been warning that all is not well with U.S. defense stocks. Still, with the U.S. Navy supposedly gearing up to deter Chinese aggression against Taiwan and the Philippines, and the military in general winning sizable support to build up to deter Russian aggression in Ukraine, investors may have been surprised to see this kind of weakness at America's naval shipbuilders. And it got me to wondering: Might they be surprised enough to consider investing in some foreign defense stocks instead?

Image source: Getty Images.

Britannia rules (under) the waves

Around the same time General Dynamics and HII were disappointing investors here in the U.S., a couple of news items surfaced that piqued my interest in defense contractors on the other side of the ocean -- the United Kingdom's Rolls-Royce (RYCEY 1.69%) and BAE Systems (BAES.Y -1.99%) in particular.

In January, for example, analysts at new defense-market publication Ignition highlighted a new $11.3 billion contract awarded by the U.K.'s government to Rolls-Royce, to build nuclear power systems for the Royal Navy's submarine fleet.

The contract covers support for the RN's current fleet of four Vanguard-class nuclear-powered ballistic missile submarines, also known as SSBNs, each of which carries Trident II D5 missiles from Lockheed Martin (LMT 0.15%), and each of which is powered by a Rolls-Royce PWR2 nuclear reactor. The contract also encompasses the production of upgraded PWR3 nuclear reactors for the country's upcoming fleet of three (or perhaps four) new Dreadnought-class SSBNs.

And here's the thing that may really astound you: The U.K. is projecting that building the Dreadnoughts will cost $38.8 billion in total. That means that Rolls-Royce's part of this project may amount to as much as 29% of all funds that will be spent on the upgrade.

BAE Systems glows green

Where will the rest of the money go, you ask? Well, I gave a bit of a hint already, but the answer is: to BAE Systems. While Rolls-Royce builds the engines for the Dreadnoughts, BAE Systems has been given primary responsibility (and billions of dollars in development funding already) for building the submarines themselves.

Working in cooperation with Rolls-Royce and with the Submarine Delivery Agency under the U.K. Ministry of Defence, BAE plans to bring Dreadnoughts into service sometime in the early 2030s. That, as luck would have it, is right around the deadline for Rolls-Royce's $11.3 billion nuclear power plant contract.

Should you invest in Rolls-Royce or BAE Systems stock?

And now we get to the part that defense investors have been waiting for. Yes, Rolls-Royce and BAE Systems have both won lucrative contracts for Dreadnought development. But are their stocks worth buying?

Here are the numbers I'd focus on in answering that question:

Data source: Company filings, Yahoo! Finance, author calculations. PEG ratio = ratio of price-to-earnings to growth rate.

As you can see, despite its larger market capitalization, Rolls-Royce is profitable enough. And it's growing fast enough to make it arguably the better value of the two stocks -- but that's a closer call than you might think. Valued on either net income or on free cash flow, Rolls-Royce looks significantly cheaper than BAE Systems. Its civilian airplane engine business also adds a bit of diversification should defense (or in this case, "defence") stocks fall out of favor.

On the other hand, BAE Systems, while more expensive, currently pays a respectable 2.6% dividend yield, which Rolls-Royce does not. Factor that into the equation, and the valuations of these two British stocks become almost identical.

Which one would I choose? Ideally neither, because while reasonably priced, neither stock quite fits my definition of a value stock -- one with a total return ratio of 1.0 or less. But on balance I still think I slightly prefer Rolls-Royce over BAE Systems. Its net debt load is lighter ($1.2 billion versus nearly $10 billion) despite having a larger market cap and a more diversified book of business, I think this makes Rolls-Royce the safer bet for individual investors.