In a shaky stock market environment, there is no better place to turn than the defense contractors. Leading the S&P index by about 20% in 2008 (the 8th straight year of better relative performance), the so-called “big five" have their work cut out for them in 2008 and beyond. It is pretty much a foregone conclusion that defense spending will increase this year.
With high global threat levels, the United States defense budget has historically increased regardless of the presidential party in power. Don't listen to the fools that tell you a democrat president will cut the defense budget, that is simply not true. The funding put into homeland security as well as our defense budget is set to increase (President Bush recently introduced a $3.1 trillion dollar budget) regardless of the War on Terror's outcome, and the big five defense firms are set to benefit.
There are pros and cons to each of the main defense contractors, but I want to defend the notion that they are all winners in this environment. Which companies? I am talking about United Technologies, Lockheed Martin, General Dynamics, Raytheon and Northrop-Grumman.
United Technologies (NYSE: UTX)
UTX is the largest of the Defense companies, and offers a favorable mix of risk-reward at this point. A widely expected healthy first quarter could be a huge catalyst for the rest of the year. United Technologies does everything from industrial turbine engines to elevators, and it is this diversity that really makes them the General Electric of defense contractors. The weak dollar actually bolsters a potential earnings beat (+15%) for 2008, despite a rocky economy, because European sales account for about 25% of United Technologies’ total.
Many investors have voiced concern over the recent announcement to acquire Diebold. I believe that speculation since the bid isn't likely to be hostile and the relative size of the expense is small on UTX's books. Other potential risks include a weakening in commercial construction markets and a slowing residential construction recovery, but I think that a strong aerospace backlog along with a geographic diversity balances their resume enough to ensure a strong year under even the worst conditions.
Lockheed Martin (NYSE: LMT)
Lockheed Martin is the kind of company that never gives you the value you want, but always performs with off the charts fundamentals and margins. I think a lot of analysts with HOLD ratings on the firm are underestimating LMT's ability to drive profit out of even the bleakest of market conditions. This company has the most risk behind a 2009 administration changeover, but the threat posed is hyped beyond what will actually happen in my honest opinion.
Truth be told, I'd rather have you in a different defense contractor in the short term, but LMT's performance is truly remarkable and I still have a BUY on these perennial EPS outperformers. They were up 32.8% during the last 2001 recession, and are poised to outperform the market again in 2008. What's more, their 10-year annualized return is up at 7.3%. What I am trying to say is, Lockheed Martin is historically one of the top performers in a recession, and this go-round shouldn't be any different.
General Dynamics (NYSE: GD)
General Dynamics is poised to be the largest holding in the Nittany Lion Fund, LLC. , and I am generally stoked about their prospects for the year. GD has a leading market position in the areas essential to the U. S. military and has a strong track record of generating capital under every market condition imaginable.
The new Gulfstream G650 aircraft, from the leading unit of GD Aerospace, has really improved on fuel efficiency and speed (among other things) and I feel like the long-awaited release could really benefit sales. This is pretty much the world to GD, and offers a huge amount of visibility with low risk. Other than this, I continue to recommend General Dynamics because of their “no surprises" business model that continues to perform well, offering beatable 2008 EPS guidance and great long term prospects, that guarantees a safe investment.
Raytheon (NYSE: RTN)
RTN is really a conviction buy in the fact that they have an increasing foreign exposure, above average cash flow and a recession-proof portfolio. A lot of investors have Raytheon as the #1 defense company stock for 2008, and I really can't argue with them. I do not like the fact that this company is overly tied to the Bush Administration, and would be effected slightly by a reduced US presence in Iraq or a more pro-China President (because of arms supplies to Taiwan). However, you need to consider that the defense budget is relatively stable.
Raytheon is set to benefit from some big contracts in homeland and border security, such as a $5+ billion Saudi middle east border contract and the ability to capitalize on cyber security after acquiring Oakley. Strong foreign orders and redeployment of cash should drive Raytheon into a profitable 2008/2009, and I stand by the hype.
Northrop-Grumman (NYSE: NOC)
All the buzz over Northrop-Grumman has been the contract win over Boeing to supply a new tanker worth a potential $35 billion. Despite Boeing's dispute, NOC will more than likely come out with the win on this one. Regardless, I feel that the bigger development is Northrop's “Guardian System, " a missile-jamming “pod" that can be attached to aircraft to prevent them from getting shot down in hostile flight areas. Before this system was released on March 26th, it was widely expected to favor Raytheon and BAE Systems. . . I think this can be a huge driver for NOC that has really gone unnoticed in the market.
Northrop is a steady performer at an attractive price. With a PEG at 0.88 and a Beta at just 0.38, they seem to be ripe for investment. Not only are the valued well, but they have that low debt that we love (debt/equity is just 0.23). The numbers are good, they are getting contracts nobody thought they would get, and they carry low risk in a poor market environment. NOC is good.
The power behind defense in a down market is the ability to lock in contracts, backed by a rising national defense budget, for the long term. The big five all have their advantages, and I would expect most of them to capitalize regardless of what twists and turns are in store for the rest of the market. Sometimes, the best offense is a good defense!
-The Net Fool
The author of this article is Jim “The Net Fool".
He is owner of theNetFool.com If you'd like to learn more about the stock market, you can visit http://www.thenetfool.com You'll find all the information you need!