Major Defense Stocks Ignoring Politics
Douglas is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
It has been approximately one month since most of the major defense contractors released their earnings results. Since that time, the stocks of these companies have appreciated with several hitting new 52-week highs. This performance has come despite the looming threat of dramatic budget cuts, largely as a result of the sequestration plan that is set to take effect in January.
What is perhaps of even greater interest is the fact that there seems to be little correlation between how these stocks have performed over the last month and the size of the cuts faced by the company. By looking at the combination of each company’s recent earning, recent performance and the expected impact of budget changes, one may be able to glean some insight into which companies offer buying opportunities and which have significant downside.
A Brief Word on Sequestration
Under the sequestration plan, legislators were tasked with cutting an impressive $1.2 trillion from specific areas of the budget; the concept was to attempt a bipartisan reduction in spending during a period in which government spending has come under particular scrutiny. When the inevitable failure occurred, automatic cuts would be effectuated. These reductions targeted each party’s respective pet projects: social programs for the Democrats and defense for the Republicans. The mandatory cuts were to decrease the defense budget by $500 million over the planned cuts of $497 million already slated for the next decade. The combination of the planned cuts, which have already had an impact, and those that would take effect if sequestration goes into effect has the potential to dramatically alter the landscape.
The Players and the Plays
Northrop Grumman (NYSE: NOC) – Leading the group in terms of the last month’s performance, up over 9%, Northrop has performed well despite a weak earnings report. Revenue fell by nearly $200 million and earnings fell to $480 from $520 a year earlier. On the positive side, the company improved its operating margin from 12 to 12.5 percent. Reports suggest that the company’s participation in the manufacture of its “block 30” Global Hawk unmanned drone will be terminated. The company does continue to maintain the most attractive valuation multiple with a P/E of 9. Overall, the market seems to be ignoring some compelling negatives. At current levels there are better options unless one is looking for a short.
Lockheed Martin (NYSE: LMT) – The next strongest price performer has been Lockheed, which is up just under 7.5%. Management acknowledged the potential headwinds in the last earnings release, but still increased guidance for the rest of the year. Net income rose to $781 million from $748 million and earnings handily beat estimates at $2.38 relative to an average expectation of $1.91. Lockheed is a part of the team that was selected to build the U.S. Navy’s next-generation coastal warfare vessel, it recently was awarded $64 million to continue work with the Army on Joint Air-to-Ground missile technology and it set to begin building the InSight vehicle headed for Mars. Lockheed looks to be one of the best positioned players and is a strong buy.
General Dynamics (NYSE: GD) – Up approximately 3.5% in the past month, General Dynamics is perhaps the most neutral of the stocks in this group. The company cut costs, boosted its operating margin and increased revenue by 0.5%, but still saw earnings fall by 4.8% last quarter. The company recently announced that it has been awarded a U.S. Army contract worth $53.9 million to produce 13,000 units of the Joint Tactical Radio System. The company is in the middle of the pack in most respects and is likely to be a market performer for the present.
Boeing (NYSE: BA) – This stock climbed about 2.5% over the measurement period. Boeing, more than any of its peers, has good diversification outside of defense. In the most recent quarter, the company’s overall numbers were strong, but earnings in the defense division fell by six percent. The Navy recently awarded a $40 million plus incentives contract to the company, but a 20% reduction in planned purchases of the V-22 Osprey plane-helicopter hybrid will mean a significant drawdown in revenue over the next five years. This is the stock to buy for investors wanting defense exposure with some built-in diversification.
These four companies have been solid plays for investors over the years and continue to be in the current environment. While anything can happen in an election year, the market seems to be ignoring the potential carnage on the horizon. Many industry experts fully expect the sequestration situation to be addressed before it takes effect, but playing chicken with $500 million is a real gamble. Both the currently planned cuts and potential future cuts will not hurt contractors equally. Sorting through the red tape of Washington can provide valuable insight when deciding where to dedicate capital.
Mr. Ehrman has no positions in the stocks mentioned above. The Motley Fool owns shares of General Dynamics, Lockheed Martin, and Northrop Grumman. 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. If you have questions about this post or the Fool’s blog network, click here for information.