Does the Sequester Threaten These Defense Stocks?

The sequester is certainly a big deal for defense stocks, as evidenced by former Defense Secretary Leon Panetta calling the sequester a "disaster" for the Defense Department. But for investors, how should this impact the way you view these stocks?

Ultimately, most believe that some kind of deal paring down the sequester will get done at some point. Don't hold your breath in Washington, but, if this is the case, this will be mostly a short-term distraction for defense stocks. 

Taking a long-term view, the future of the F-35, the biggest defense contract in history, is potentially a bigger deal for defense contractors. Led by Lockheed Martin (LMT -0.20%), pretty much all of the major contractors have some skin in the game. With several countries delaying or reducing the amount of F-35s they will buy, it increases the cost-per-plane for a program that is already delayed and significantly over budget. 

In the video below, analyst Brendan Byrnes discusses how the sequester, the F-35 program, and the growing cyber security threat affects the big defense contractors. Brendan also gives his top stock in the sector. 

Andrew: Hey Fools, Andrew Tonner here. I'm joined today by Brendan Byrnes, our Motley Fool Analyst.

Brendan, one of the big storylines affecting the industrial space, defense stocks especially, is the sequester and the short-term spending cuts. There really have been a lot of people freaked out, but when you look at them in context as an investor in the defense space, what are your thoughts on it?

Brendan: Yeah, it's getting all the headlines right now, the sequester. We've seen this coming -- $500 billion over the next 10 years. Ultimately, something will probably get worked out. Both sides are saying this is going to be too painful.

But the bigger story here, overall, is there's just going to be less money to go around for these big defense contractors. That's why you're seeing them priced so cheaply and, of course, when you look at the world's biggest defense contract of all time, Lockheed Martin heading the F35 program, this is a huge, huge program, and it has implications for every single defense contractor.

When you look at the cost of this program, up 70% since 2001, it's getting a lot of people nervous, not just the United States, but international partners, as well. Australia is planning to buy 100 F35s; it's probably not going to be that many. Canada announced it could cut 65 of them. Italy, fewer orders; and then Turkey, of course, is delaying the program for two years.

What happens is, when fewer international customers buy these F35s, the cost per unit goes up, so ultimately, I think this will get reduced a little bit for Lockheed Martin, even in the United States, which has, again, implications for all the defense, especially United Technologies (RTX -0.35%) through its Pratt Whitney subsidiary, which makes the engines.

Another trend to watch in defense is cyber security. We've seen Raytheon, General Dynamics, and Northrop Grumman all make acquisitions related to cyber security in 2012 with China, we know, getting increasingly involved with that. That's possibly a major growth area, going forward.

The defense industry, looking at these stocks -- Lockheed Martin, Raytheon trading at about 10X earnings, Northrop Grumman trading at about 8X earnings -- there's a reason they're this cheap. We have a lot of uncertainty baked in here.

I think Lockheed Martin could be a solid play if you're looking for maybe a little bit of defensive stock, a 5.2% dividend, so you could collect that. I wouldn't expect a ton of growth, going forward, but in this space I like United Technologies. It's a stock I own, it's better diversified. They have a bunch of different units; Otis Elevators, Carrier, that can help them better diversify, also other commercial aviation interests.

I would look for a more diversified play in this space, but again Lockheed Martin could be a solid value play for a dividend-seeking investor.

Andrew: Definitely it's interesting connecting the dots between these macro storylines we see, and boiling it down to specifics.

Brendan: It's just a lot of uncertainty, which freaks out investors.