The Top 5 Defense Stocks: Pros & Cons

How Boeing, Lockheed Martin, General Dynamics, Northrop Grumman and Raytheon stack up post-earnings

The best place to start is with the Pentagon’s biggest contractors as ranked by Deloitte in a report released in April. The top five are Boeing (NYSE:BA), Lockheed Martin (NYSE:LMT),General Dynamics (NYSE:GD), Northrop Grumman(NYSE:NOC) and Raytheon (NYSE:RTN).

For a comprehensive breakdown of the defense/aerospace industry, check out this expert analysis by InvestorPlace’s Hilary Kramer. As she points out, the expected defense cuts haven’t hit these stocks too hard — a theme that played out in the companies’ quarterly earnings reports last week.

Here’s our breakdown of last week’s earnings, the good and the bad of these defense-sector Goliaths and our verdict on which ones should soar and which could sink.

Boeing

With $68.7 billion in revenue last year, BA is the defense/aerospace industry’s top gun. All of the key metrics rose for Boeing last year: Revenue was up nearly 7%, operating profit grew by 17.6% and margin growth was 10%. Share price and market cap grew by 12.4% and 13.9%, respectively.

Earnings: Boeing was the belle of the ball in last week’s defense/aerospace earnings parade. First-quarter profit rose a whopping 58%, to $922 million ($1.22 a share), on the strength of its robust commercial-airplane business. Revenue also rose by 3% in the quarter, to nearly $19.4 billion.

Good: Boeing is selling a lot of commercial airplanes, including the $6 billion deal announced Monday to sell 20 777 jets to China Eastern Airlines. Boeing creatively agreed to buy five Airbus A340s from China Eastern to seal the deal. The company delivered 137 commercial aircraft in the first quarter, versus 104 in the same quarter last year. Another big bright spot: BA has racked up 300 orders for the new, re-engined 737 MAX, which will compete head-to-head with Airbus’ fuel-efficient A320neo.

Bad: The biggest potential problem for Boeing in the short term remains the impact of high fuel prices on airlines and the economic challenges in Europe. Although the much-delayed 787 Dreamliner is getting back on track, costs remain high.

In the defense sector, BA could face pretax losses of $317 million in a rocket-reimbursement dispute, according to Space News.

Stock: With a market cap of $58 billion, BA is trading at around $77.50, about 37% above its 52-week low last August. The stock has a price-to-earnings-growth (PEG) ratio of 1.5, suggesting it may be oversold. Its forward P-E of over 13 is a little higher than many companies in this sector, and its current dividend yield of 2.3% is a little lower.

Verdict: BA’s success was due to strong deliveries in its commercial-airplanes unit, not to its federal government contracting business, making it the most insulated of the Big 5 to massive defense cuts. Even though it’s a little more expensive than I’d prefer right now, I like BA on the strength of its global commercial-aircraft sales growth — if it can produce the 737 MAX without repeating the delays and glitches that bedeviled the 787 and 747-8. The company also must keep production and deliveries on track with those models. While I rank BA a buy now, I wouldn’t pursue it too ardently — my comfort level would end around $82.

Lockheed Martin

As the largest defense-industry pure play, Lockheed Martin‘s (NYSE:LMT) $46.5 billion in revenue last year places it solidly in second place, but its metrics are less attractive than Boeing’s. Although the share price grew 15% and market cap rose by 4%, revenue was flat. Operating margin fell by 1.7% in 2011.

Earnings: LMT beat the Street last week with $688 million in profit ($2.03 a share) on $11.3 billion in revenue. Last year’s first-quarter earnings were $530 million ($1.50), and analysts had expected earnings of $1.70 a share on $10.6 billion in revenue.

Good: The company already has reduced overhead costs by $1.2 billion. It removed 1.5 million square feet of facilities space from 2010 to 2011 and plans to remove nearly 3 million more square feet of space by 2014. Margins for LMT’s electronic systems were 15% in the first quarter, particularly in its missiles and fire-control systems.

Bad: LMT is the prime contractor on the delay- and cost-overrun-plagued F-35 Joint Strike Fighter. In March the Pentagon announced that it will delay delivery of 179 of the planes for five years. Japan, which has placed orders for 42 of the fighter jets, said earlier this year it will cancel the deal if there are any delivery delays or price increases.

Stock: With a market cap of $29.5 billion, LMT is trading at around $91, 37% above its 52-week low last August. It has a PEG ratio of nearly 1.7, indicating that it may be overvalued. It has a forward P-E of about 11 and an attractive current dividend yield of 4.4%.

Verdict: In good times it’s a boon to investors that LMT has its fingers in a lot of pots. But with the defense sector’s many challenges, it seems more like those fingers are just trying to plug holes in the dike. LMT is front and center in a lot of high-profile, potentially endangered defense contracts, including the F-35 and the Littoral Combat Ship.

The company has non-defense federal customers, too: the FAA, NASA, National Security Agency and the Energy Department, but their budgets will be cut, too. Still, Lockheed is doing a very good job of cutting costs so far. If you’re in LMT now, I’d hold, but keep a very close eye on two things: the sequestration debate and whether Japan cancels its F-35s. Either of those events could mean danger for LMT.

General Dynamics

General Dynamics (NYSE:GD) had $32.7 billion in revenue last year, but year-over-year growth was flat, while profit and margins declined by 3%. GD’s share price slipped more than 6%, and its market cap fell by nearly 12%. The company’s aerospace, combat and marine-systems businesses, in particular, were challenged in 2011.

Earnings: GD’s first-quarter earnings missed analysts’ estimates on the top and bottom lines. Net income in the first quarter fell to $564 million ($1.57 a share) on revenue of nearly $5.6 billion. Wall Street expected revenue of $7.9 billion and an EPS of $1.69. For the same quarter last year, GD reported net income of $618 million ($1.64 a share).

Good: General Dynamics’ best prospects are in its Gulfstream business jet unit, which grew first quarter sales by 20% and profit by 18%. The company has an opportunity in the Marine Systems unit with the Navy’s potential order of 9 DDG-51 Destroyers and 9 Virginia-class nuclear attack submarines.

Bad: Income fell 27% in the combat-systems unit, which produces the Abrams battle tank, and 21% in its information systems and technology unit. Europe has been fraught with challenges for GD, causing the company to take a $67 million non-cash charge. The Defense Department’s fiscal 2013 budget will slash $800 million from GD’s Advanced Global Hawk drones program. GD also is a subcontractor on LMT’s vulnerable F-35.

Stock: With a market cap of $24.7 billion, GD is trading at around $68.50, about 27% above its 52-week low last September. It has a PEG ratio of 1.5, an attractively low forward P-E of 9 and a current dividend yield of 3%.

Verdict: Once again, commercial-airplane sales could be the silver lining in the cloud of looming federal budget cuts. While it won’t help GD soar nearly as high as Boeing, the business-jet niche, in particular, should help offset some of the forecast declines in other businesses.

I’m not confident that GD will get all nine of the Virginia-class submarines it’s hoping for. At $2 billion a pop, it’s too juicy a budget target right now, which could mean a cut in procurement levels to five — or even four — and delayed delivery. This is another of my “hold for now, but watch closely” stocks. With GD, I’d keep an eye on Europe and see if second-quarter earnings show further deterioration in margins.

Northrop Grumman

Northrop Grumman (NYSE:NOC) experienced a 6% drop in revenue, to $26.4 billion, in 2011, but aggressive cost management and a high percentage of flexibly priced long-term contracts boosted last year’s profit by nearly 16%, and margins grew by a robust 23.5%. Share price and market cap fared badly, however, falling by nearly 10% and 19%, respectively. Shipbuilding and aerospace operations have been among the most pressured.

Earnings: NOC’s first-quarter earnings nosed up about 2%, to $506 million ($1.96 a share), as the company’s cost-cutting initiatives managed to offset revenues that were $500 million lower than last year.

Good: Cost-cutting is a huge priority at NOC, so it hopes to boost margins through layoffs and other measures. The company also could benefit from a growing commercial market for unmanned drone aircraft, particularly for police departments.

Bad: Northrop was particularly hard hit by budget cuts on LMT’s F-35 Joint Strike Fighter and Boeing’s F/A-18 Hornet. The company is a major subcontractor on both programs. Even more challenging: Sales have slipped in NOC’s aerospace, technical and information-services units.

Stock: With a market cap of nearly $16 billion, the stock is trading at around $63.50, nearly 30% above its 52-week low last August. It has a PEG ratio of about 2.5, making it appear significantly overvalued compared with its peers. NOC also has a forward P-E of 9 and a current dividend yield of 3.1%.

Verdict: NOC has some outstanding and sophisticated approaches to cybersecurity at a time when Congress is moving legislation ahead that could foster a war on cyber threats. That’s why I’m concerned that sales are down in Northrop Grumman’s information-services unit. The obstacles facing other divisions are even more challenging. Cost-cutting and layoffs will help, but the company could be forced to cut intellectual muscle that it will need once the sector rebounds. I love this company, but I hate the stock right now — I rank it a sell, at least in the short term.

Raytheon

Raytheon‘s (NYSE:RTN) revenue was flat last year at $24.8 billion, but it still managed to grow profit by nearly 10% and margins by 11%. The missile and integrated-defense-systems company, which also is on a quest to purge waste from its operations, saw a 4% increase in its share price last year, though its market cap stayed about the same.

Earnings: RTN’s first-quarter earnings soared on missile sales and the deployment of advanced-information technology to boost productivity. Profit grew by 17%, to $448 million ($1.33 a share), on sales of $5.9 billion. The company raised its full-year guidance to $5.00 to $5.15 from its earlier estimate of $4.90 to $5.05.

Good: Raytheon’s strong position in international markets — 25% of total first-quarter sales were to non-U.S. customers, particularly in the Middle East and Asia. Large radars and air- and missile-defense systems were strong. Profit in the company’s integrated-defense-systems unit, which includes the Patriot and Aegis weapon systems, rose more than 11% in the quarter. Cyber security spending also is giving a boost to RTN’s intelligence and information systems.

Bad: Network-centric operations sales and traditional sales of Army products have slipped. And as with all defense contractors, the possibility of “sequestration” — across-the-board automatic defense cuts set to take effect in January 2013 — will have a huge impact on U.S. federal sales.

Stock: With a market cap of $18.2 billion, RTN is trading at around $54.50; it set a new 52-week high last week. It has the best PEG ratio in this group at 1.2, indicating that the stock is fairly valued. RTN has a forward P-E of about 10 and a current dividend yield of 3.7%.

Verdict: The company has repurchased nearly 8 million shares and is raising its dividend by 16%, to $2. RTN is doing a lot of the right things, including cultivating a strong international presence and solid positioning in the cyber-security and missile-systems area.

Fundamentals are good compared with most of its peers. I like Raytheon’s margin growth as well as the dividend yield. RTN could be a buy now, though I wouldn’t jump in much higher than $58. Since it just hit a new 52-week high, I might wait to try to buy it on a dip.

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