It's Time to Buy These Defense Contractors

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To bolster economic growth, reduce malignant spending and prevent another fiscal cliff debacle, the 2013 U.S defense budget has been cut by $487 billion. And now, another $500 billion worth of cuts is being recommended. While this is bad news for many U.S defense contractors, the recent string of events has opened up new investment opportunities.

Going beyond the budget!

According to the auditor general’s report, the realistic cost of 65 F-35 aircrafts is estimated to be around $45.4 billion. Since the U.S military estimated a total cost of $25 billion, the sudden surge in the aircraft budget created a widespread controversy. And when the leaked documents from the Pentagon indicated that the F-35 program could be scrapped, the market was spooked. Since Lockheed Martin (NYSE: LMT) manufactures these aircraft, the cancelled orders was bad news for the company.

However, the U.S military recently made it clear that it won’t cancel the pending orders of these aircrafts. An official stated, “Cancelling the programme would be detrimental to our national defense.” Officials also stated that there are 10 nations involved in the F-35 program, which makes it nearly impossible to scrap or dismantle the entire program. So, it will most likely continue with its F-35 orders, and look to save costs in other arenas.

And just when the Pentagon seemed tired of the $392 billion worth of F-35s, it went ahead last week and ordered 71 more F-35 aircraft. According to the deal, the government has secured a 4% discount on 36 radar evading aircraft. And the remaining 35 aircraft will be procured at an 8% discount. This corroborates the fact that the U.S will continue to build its F-35 fleet in the coming years.

Ways to profit from this

Without a doubt, the development and maintenance contracts of F-35s will benefit Lockheed Martin the most.  The company generates around 15% of its revenue from the sale of aircraft, and the surge of new orders will certainly diversify its income streams. The defense contractor currently produces around 36 fighter aircraft per year and is looking to ramp up its production to 150 fighter aircraft per year. So, needless to say, the revenue from F-35 aircraft will now hold a greater revenue share.

On the other hand, Northrop Grumman (NYSE: NOC) provides CNI systems (Communication, Navigation and Identification) for F-35 aircraft. The company was awarded these contracts back in 2001, and if it is able to retain its product quality and punctuality, the contract can last until 2035. The company recorded $1.3 billion worth of revenue from its F-35 orders in 2012. And since the production of F-35 aircraft is expected to quadruple from 2013 onward, Northrop is expected to rake in around $4 billion of additional fiscal 2013 revenue.

Moving on to the next beneficiary, United Technologies (NYSE: UTX) manufactures engines for F-35 aircraft. Just a month before the Pentagon agreed to buy 71 more aircraft, United Technologies signed a $1 billion contract with Lockheed Martin, under which United will provide engines for 35 aircraft. The engine manufacturer is giving an 8% discount on its engines, which has sweetened the deal for Lockheed Martin. And now that there is a fresh spurt of workload, analysts estimate that United could receive another big order worth between $4 billion and $5 billion.

Final words

It's worth noting that the F-35 program is the most expensive program in U.S Defense spending history. And since Lockheed Martin, Northrop Grumman and United Technologies are directly related to its development, the rising demand for the aircraft will benefit all three companies. Therefore, I believe that initiating long positions in all the mentioned companies, would be a great way to spread the risks and reap healthy rewards.

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Piyush Arora has no position in any stocks mentioned. The Motley Fool owns shares of LMT and NOC. 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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