Aerospace and Defense Stocks: Worth The Risk?

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The United States overspends on military projects, and as the national debt and sequestration move to the forefront of political debate, this oversized military spending is vulnerable. This is a bad thing for the aerospace/defense industry.

That being said, are there any stocks in this group that are cheap enough to warrant embracing these risks?

Industry challenges

Lockheed Martin (NYSE: LMT) expects a record profit in 2013, even though the company and other suppliers to the Pentagon could witness a decline in spending needed to reduce the U.S. deficit. The company expects to earn a profit of $9.10 per share by 2013; this would be its highest ever. The company projects earnings for a full-year profit in 2013 of $8.80 to $9.10 per share, more than the $8.28 per share average estimate of 22 analysts compiled by Bloomberg. Howard Rubel, an analyst of Jefferies Group, said that the company’s performance during the fourth quarter of 2012 displayed a broad-based demand for its offerings. The company’s growth in backlog was inspiring, representing a 2% increase to $82.3 billion by 2012.

Two other defense contractors, Raytheon (NYSE: RTN) and General Dynamics, forecasted their 2013 results below analyst predictions. Reduction in the U.S. defense spending of $45 billion through September is expected to be implemented unless President Obama and Congress can agree by March to find an alternative method to reduce the federal deficit.

According Marillyn Hewson, President and Chief Executive Officer of Lockheed Martin, “As we look at our go-forward plan for this year, we have a very strong portfolio and a solid plan in place. And even as we look at sequestration and potential budget reductions, we’re not looking at planned job reductions.” The company’s fate depends upon its biggest program, the F-35 jet fighter, which is also the Pentagon’s costliest weapon system, with a project development cost of $395.7 billion. During the fourth quarter of 2012, the company’s earnings from continuing operations were $569 million, or $1.73 per share, as compared to $698 million, or $2.14 per share, during the fourth quarter of 2011. Meanwhile the average estimates of 21 analysts compiled by the Bloomberg was $1.82 per share profit.

The company is also protected against threat of budget cuts thanks to the Pentagon’s commitment to the F-35. In January, the company entered into a contract with the Pentagon for its fifth lot of jets, obligating funds and confirming continuous production in spite of the automatic cuts that could take place in March. The company expects to bring to close contracts with the Pentagon for two more lots of the planes by mid-2013 and to commence work on another batch that would turn out jets for Japan and Israel. In 2013, it plans to provide different customers with a total of 36 F-35 jets, or 20% more planes as compared to 2012.

Lockheed and Raytheon’s profits for 2013 are expected to increase due to tax credits the companies could claim for research and development as per the tax contract signed into law by Obama in February 2013. The law that would extend the tax credit is expected to add 23 cents per share to Lockheed’s earnings in 2013 and about 15 cents per share to Raytheon’s earnings.

Raytheon forecast that its earnings from continuing operations for 2013 would be $5.16 to $5.31 per share. The average of 22 analysts compiled by Bloomberg expects earnings of $5.46 per share on sales of $24.1 billion. During the fourth quarter of 2012, Raytheon’s profit from continuing operations for 2012 was $466 million, or $1.41 per share, as compared to $539 million, or $1.56 per share, in the fourth quarter of 2011. According to Dave Wajsgras, the Chief Financial Officer of Raytheon, the company has a record backlog of orders “that bodes well for the next two to three years. It also has a very strong pipeline of opportunities internationally.” The company’s international sales may increase by 3%-5% in 2013 offsetting a similar decline in sales domestically.

Northrop Grumman (NYSE: NOC) reported that it fourth-quarter earnings fell 2.7%, but expects that its 2013 earnings would exceed analysts’ estimates. The company’s net income from continuing operations was $533 million, or $2.14 per share, as compared to $550 million, or $2.09 per share, during the previous year. The company’s sales dropped 1% to $6.48 billion.

The average expected earnings per share from 20 analysts compiled by Bloomberg is $1.74 per share. The company expects profit in 2013 from continuing operations of $6.85 to $7.15 per share on sales of about $24 billion. According to Chairman and Chief Executive Officer Wes Bush, the company has divested low-margin businesses, including shipbuilding, and reduced jobs to enhance its earnings. The company has reduced its workforce by 16%-17% and plans to reduce the square footage of facilities by approximately 12%.

Boeing (NYSE: BA) is already under pressure with the grounding of its 787 Dreamliner and union engineer labor issues, which would threaten its upheaval as it tries to fix the plane and resume deliveries to customers. The company is focusing on boosting the jet production to pare a seven-year order backlog and develop upgrades for three models. According to Brad Lawrence, Chief Executive Officer of Esterline Technologies, “To have your engineers’ union be this disconnected that it would walk out right when your company needs you most, it would just be horrible.” According to Bloomberg, Esterline derives 8.9% of its revenues from Boeing.

Valuation

Northrop Grumman is attractively-priced with low valuation multiples and manageable debt levels:

Ticker

Company

P/E

P/S

P/B

P/FCF

D/E

LMT

Lockheed Martin

10.51

0.6

732.25

NA

21.76

NOC

Northrop Grumman

8.4

0.62

1.65

8.77

0.41

BA

Boeing

14.68

0.69

9.67

12.62

1.77

RTN

Raytheon

9.55

0.73

2.22

NA

0.59

GD

General Dynamics

NA

0.75

2.06

17.5

0.34

Lockheed Martin is financed overwhelmingly by liabilities, making it too risky to consider. Also not that all the stocks on this list are more expensive than Northrop Grumman.

Conclusion

Value investors who are interested in adding an aerospace/defense stock to their holdings should consider Northrop Grumman as a buy candidate based on its attractively-low valuation.


BillEdson11 has no position in any stocks mentioned. The Motley Fool owns shares of Lockheed Martin, Northrop Grumman, and Raytheon Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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