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Getting Ready To Attack The Defense Stocks

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

It seems the political battle over government spending is about to heat up again. After a month and a half respite, this latest round of squabbling centers on the $1.2 trillion sequester, a mandated across-the-board set of spending cuts. If enacted, the sequester is expected to hit U.S. defense spending hard. Leon Panetta, outgoing Secretary of Defense, said that if the billions of dollars in cuts are allowed to stand he would have to throw the country's national defense strategy "out the window," and the United States would no longer be a first-rate power.

Anxieties about the defense stocks will likely increase as politicians negotiate and the March 1st sequester deadline approaches. Share prices should fall and excessive fear might create an attractive buying opportunity.

In anticipation of a potential defense stock purchase, three main questions need to be considered:

1. Are their long-term prospects decent?

The defense stocks, namely Northrop Grumman (NYSE: NOC), Raytheon (NYSE: RTN), Lockheed Martin (NYSE: LMT), and General Dynamics (NYSE: GD), have already been under pressure due to expected revenue loss from winding up operations in Afghanistan and other recent cuts.

Northrop Grumman, after adjusting for the spin-off of its shipbuilding business, has seen the share price fall from a 2007 high of $85 to a low of $61 in 2012. Raytheon has had a similar drop from $65 to a $47 per share low. Lockheed Martin and General Dynamics were not immune with their stocks falling 30% and 35%, respectively, from 2007 highs.

But there is a compelling argument that the future might not be so dire.

Military power is likely to be a growing strongpoint for backstopping America’s interests overseas. Our dominant economic power was an effective instrument in dealing with other nation states for many years, but now with vibrant growth in the emerging markets, it seems this power does not have the punch it once had. The nominal effect of some extremely harsh sanctions on Iran and North Korea is an example of the current limitations of economic persuasion.

Another example of military power likely dominating economic strength in supporting U.S interests can be seen in the Department of Defense (DOD) strategy of focusing on Southern Asia. While the U.S. can offer some economic benefit to the countries in that region, it seems clear that our ability to offer a territorial defense will garner the closest ties.

Besides China's fragile relations with its Asian neighbors, instability in North Africa, friction in the Korean peninsula and expanding tension in the Middle East also increase the chance that the U.S. will eventually have to exhibit its military resource.

2. What's their risk from the sequester?

The sequester and other identified cutbacks look to reduce defense spending by about $850 billion over a ten year period or $85 billion a year. Since total U.S. defense spending runs about $1.1 trillion per year that would be a cut of roughly 8%.

If we concentrate only on the DOD's portion of spending or around $700 billion per year, a direct $85 billion hit comes to about 12%. Thus, expecting a 12% reduction in annual revenues might be a reasonable benchmark for defense company risk.

3. What's their fair value?

Northrop Grumman

Northrop Grumman had $25.2 billion in revenue in 2012 with a reported net profit margin of 7.8%. Assuming a 12% cut to revenues and a drop in margin to 6.9%, or sales of $22.5 billion and average adjusted cash earnings of $1.7 billion, Northrop looks to have a fair business value of around $80 per share based on a 12x multiplier.

Raytheon

Raytheon posted $24.4 billion in sales over the past twelve months with a reported profit margin of 7.7%. After its 12% sales cut and a drop in margin to 6.8%, Raytheon would have estimated sales of $21.8 billion and cash earnings around $1.5 billion. Using a 14x multiplier, the company's intrinsic business value is roughly $64 a share.

Lockheed Martin

Lockheed Martin had $47.1 billion in revenue for 2012 with a reported margin of 5.8%. After a 12% expected reduction to revenues and a drop in margin to 5.0%, the resulting sales of $42.1 billion and average cash profits of $2.3 billion would equate to a per share reasonable business value of around $101 based on a 14x multiplier.

General Dynamics

General Dynamics had $31.5 billion in 2012 revenue with an adjusted profit margin of 6.5%. But unlike the others, this company has a significant amount of revenue from non-defense related businesses. Assuming those business revenues remain flat with a 12% cut to the defense related business, we get a total revenue estimate of $29.3 billion. A drop in margin to 6.0% results in average adjusted cash earnings of $2.0 billion and using a capitalizing multiplier of 14x, General Dynamics looks to have a fair value of near $80 per share.

The future for defense stocks may not be as grim as anticipated even with an implementation of the sequester. It might be worth keeping an eye on these stocks during the next few turbulent weeks. As major defense spending cuts loom, the increased publicity and resulting anxiety might offer a nice buying opportunity.


grahamsway (Bob Chandler) has a long position in Northrop Grumman and Raytheon. The Motley Fool owns shares of General Dynamics, 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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