Last week was a big week for defense contractors. JP Morgan Chase, one of the biggest names in investment banking, took a look at how Congress has allocated funds in the new omnibus spending bill,  crunched numbers and calculated valuations -- and reshuffled its deck of aerospace and defense stock recommendations accordingly.


Maker of the Global Hawk drone, Northrop Grumman is one of JPMorgan's favorite defense stocks. Image source: Northrop Grumman.

In a series of five action reports, StreetInsider.com described this week how JPMorgan upgraded three aerospace and defense stocks -- B/E Aerospace (NASDAQ:BEAV), Northrop Grumman (NYSE:NOC), and Textron (NYSE:TXT) -- to "overweight" and downgraded two more -- General Dynamics (NYSE:GD) and TransDigm (NYSE:TDG) -- to "neutral." Here's what these stocks cost today, where JPMorgan thinks they'll trade a year from now, and the potential profit implied by the banker's new target prices:

Company

Current Price

Price Target

Potential Profit

B/E Aerospace

$41

$54 

32%

Textron

$41

$50 

22%

Northrop Grumman

$185

$212 

15%

General Dynamics

$137

$157 

15%

TransDigm

$220

$240 

9%


So JPMorgan's recommendations make a fair amount of sense (at least assuming the banker is right about where the prices are headed). Generally speaking, the stocks with the greatest potential profits are the ones JPMorgan is recommending you buy. Those with less profit potential are the ones JP is only "neutral" on.

And that's just the kind of advice you'd expect to get from a banker with a record like JPMorgan's. Ranked among the top 10% of investors we track on Motley Fool CAPS (and we've been tracking its performance for more than seven years now), JPMorgan has also gotten the majority of its aerospace and defense stock recommendations right. It makes sense, then, that its recommendations should, well, make sense.

Then and now
But there's an interesting quirk at work at JPMorgan. Historically, this banker has been an ace stock picker in defense. But lately, its performance has begun to suffer. Examine the analyst's currently active list of aerospace and defense picks, and you'll notice that only about one in five is actually outperforming the stock market.

That's disconcerting. It also explains why JPMorgan may have decided to shake up its stock picks last week. Yet if you take a close look at how these five stocks compare, one to another, it's hard to see JPMorgan's record improving anytime soon. Here, see for yourself:

Company

P/E

5-Year Projected Growth Rate

PEG Ratio

Price-to-Sales Ratio

B/E Aerospace

26.1

14.2%

1.8

1.6

Textron

16.7

15.2%

1.1

1.1

Northrop Grumman

17.8

7.4%

2.4

1.4

General Dynamics

15.4

10.1%

1.5

1.4

TransDigm

28.0

14%

2.0

4.4

Data source: finviz.com.

Value analysis
While all are terrific businesses per se, I have to say that none of these companies' stocks look particularly cheap to me. Valued on PEG ratio, and on price-to-sales as well, they all look to be trading above fair value.

Granted, JPMorgan favorite Textron comes close to being a bargain -- it sports a PEG ratio of 1.1 (value investors prefer stocks that sell for equal to earnings or less). Textron also sells for 1.1 times sales, which is pretty close to what I consider the "normal" valuation on a defense stock. But B/E Aerospace and Northrop Grumman? Not even close.

It's also worth noting that, with the sole exception of TransDigm, each of these five companies generates poorer cash profits than its GAAP earnings suggest. TransDigm does, but even its 25.5 P/FCF ratio is nothing to brag about. So if these stocks appear expensive when valued on P/E, they're even more expensive when valued on P/FCF.

A better choice
Speaking of free cash flow, rather than any of the five stocks that JPMorgan re-rated last week -- either those it likes or those it doesn't -- I think investors would be better advised to check out a stock like Boeing (NYSE:BA) instead.

Boeing doesn't sport a particularly attractive P/E. It costs 17.6 times earnings, which seems a bit high relative to its projected 11% earnings growth rate. But the stock compares favorably with JPMorgan pick Northrop, which sports a similar P/E ratio but a much slower growth rate.

Valued on P/S, Boeing's price-to-sales ratio of 1 is a historically "fair" price to pay for a defense stock. Best of all, the company's strong free cash flow generation -- $8.7 billion in cash profits generated over the past 12 months -- works out to a very attractive P/FCF ratio of just 10.8. On an 11%-ish growth rate, and with a respectable 2.5% dividend yield, that's a very nice price.

Long story short, while I wouldn't necessarily short any of the five stocks JPMorgan looked at last week, I'm much more inclined to go long Boeing.

Rich Smith does not own shares of, nor is he short, any company named above. You can find him on Motley Fool CAPS, publicly pontificating under the handle TMFDitty, where he's currently ranked No. 300 out of more than 75,000 rated members.

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