Difficult Future for U.S Defense Firms

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

The international demand for goods produced by American arms makers has been on the rise as more and more countries are increasing defense spending to modernize armed forces. This comes at a good time for U.S.-based companies like Raytheon (NYSE: RTN)one of the biggest U.S. military contractors, and Lockheed Martin (NYSE: LMT), both of which are bracing for a fall in domestic demand due to budget cuts that have reduced military spending.

According to U.S. Air Force officials present at the 50th Paris Air Show held in the third week of June, in the last two years, America’s arms sales to international buyers have doubled, and this trend will likely continue in the coming years.

The research firm IHS believes that the Asia Pacific region will increase its defense spending by 35% to $501 billion in 2021, making it the biggest market for defense systems and equipment, ahead of North America. As this happens, defense firms will begin earning a greater portion of revenue from foreign clients. For instance, Raytheon has said that it will start generating 30% of its revenue from international sales in the near future, up from 26% last year.

Earnings beat and sequester

In its most recent quarterly results, Raytheon managed to beat both top and bottom-line estimates. Although its sales fell by 1% year-over-year to $5.88 billion, net income from continuing operations rose by 9% to $488 million.

However, as indicated earlier, budget cuts coming from sequester caused a reduction in revenue outlook to between $23.2 billion and $23.7 billion for the current fiscal year. In other words, sequestration will hit the company’s bookings by $400 million-$600 million. Its shares touched the 52-week high in mid-June and are currently trading close to that level. Although the company has been able to improve its operating margin over the years, it has achieved no revenue growth in the last two years. In the current economic environment, it is unlikely that this will change in the current fiscal year. Therefore, I do not recommend buying this stock at these price levels.

Similarly, global security and aerospace company, Lockheed Martin, is expecting a massive $825 million slice in net sales due to sequester. In its last quarterly results, like Raytheon, Lockheed Martin also managed to beat both revenue and earnings estimates. However, it has warned that some layoffs might happen in the near future. Raytheon has already announced a reorganization of its management and the elimination of 200 jobs to save $85 million in fiscal year 2013.

Budget cuts created more problems for Lockheed Martin, since the company earns more than 80% of its revenue from the U.S. This means that, although Lockheed Martin is a good long-term play and one of the few blue chip stocks that generate a yield of more than 4%, it is going to witness some volatility in the coming quarters due to the decrease in U.S. military spending.

Although I believe that its fundamentals aren’t rock solid due to its high debt levels (it has an unusually large debt to equity ratio of 20.74, which indicates that it has significantly more debt than its equity), some of these fears are allayed by the fact that Lockheed Martin generates decent free cash flow yield and is a favorite of the Pentagon.

The industry average debt-to-equity ratio is 0.84. From this perspective, Raytheon and Northrop Grumman (NYSE: NOC) are much better with debt-to-equity ratios of just 0.57 and 0.42, respectively. In its previous quarter’s results, like Raytheon and Lockheed Martin, Northrop Grumman was also able to beat both revenue and earnings estimates.

Northrop Grumman plans to buy back 25% of its shares by 2015. Analysts have noted that the company is going to return nearly all of its cash to shareholders in the coming years. The company currently has the lowest payout ratio of 28%, as compared to its two peers, but unlike them, Northrop Grumman has clearly stated its ambition to reward shareholders. Goldman Sachs recently upped its rating to "buy," yet I believe that the stock is trading near its 52-week high and a significant upside at the current price levels is highly unlikely, making a "hold" rating more appropriate.

Foreign markets

In June, Raytheon announced a $126 million contract for the non-explosive warhead SM-3 and a $115.9 million contract for providing engineering and other services related to the Patriot Air and Missile Defense System. The contract spans the U.S. and other NATO countries. The company also booked a $106 million direct commercial sale contract to an international customer for its combat-proven Paveway II family of guided munitions.

Like Raytheon, Lockheed Martin is aiming to expand its international operations to offset the fall in domestic demand. It recently launched Lockheed Martin International (LMI), which will be based in London, and Washington and will help its parent grow its business in foreign markets. The company was also recently awarded an international contract from Royal Saudi Air Force worth $21.4 million for artillery and combat equipment. Meanwhile, Northrop Grumman has entered into a three-year, $17 million contract with the United Kingdom’s Ministry of Defense. The company is also expanding into Australia and is now partnering with three more companies to boost its global supply chain.

The U.S. has made the right move by loosening export controls on its defense firms, and as a result, exports were up by 42.1% to $28.5 billion in 2012. Although American firms have bright prospects in the international markets, there is increasing competition from Chinese and Korean companies that sell military hardware and software, an arrangement worth billions of dollars in developing economies. Some countries, such as Venezuela and Pakistan, are increasing their reliance on China for defense equipment. Therefore, although American firms would like nothing more than to increase their exposure in the international market, this is going to be very challenging, particularly in the Asia Pacific region where China yields significant political clout where it would be difficult to sustain high levels of defense export growth. 

Conclusion

While Raytheon and Northrop Grumman have strong fundamentals, Lockheed Martin yields considerable influence in the domestic markets. However, in the near term, the increase in international sales is not going to offset the drop in demand coming from the sequester, and as a result, revenues will fall. Although these firms can be a decent long-term play, at the current unattractive price levels, coupled with the expected fall in sales and doubts over the industry’s ability to maintain its growth in the international markets, I would recommend staying away from these stocks. 

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Sarfaraz Khan 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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