1 Aerospace & Defense Stock To Buy, 2 To Avoid

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

In light of the projected spending cuts, the aerospace & defense sector is trading relative cheap. However, the fundamentals have actually produced strong returns and continue to largely outperform expectations. I recommend buying industry stocks with organic growth potential strong enough to weather tepid support from the government.

Boeing (NYSE: BA) Continues To Deliver, Proves Itself Undervalued

With the Department of Defense scheduled for nearly a $500 billion haircut, aerospace firms are naturally, well, playing defense. Boeing, however, may very well be the best positioned to navigate this headwind. Management has been cutting costs to lift operating margins beyond last year levels and thus far its initiative has largely paid off. Despite the challenging macro period, Boeing is still 16.8% up from its 52-week low and only 7.6% down from its 52-week high.

Going forward, there are several reasons to be optimistic about Boeing. First, it only trades at a respective 12.3x and 12.7x past and forward earnings. The company grew EPS by 13.4% annually over the past 5 years, and the rate is still expected to be north of 10% over the next 5 years. Analysts currently rate the stock around a "buy" for that reason.

Assuming the company meets expectations, 2016 EPS will come out to $7.56. At a 15x multiple, this translates to a future stock value of $113.40. Discounting backwards by 10% yields a present value roughly in-line with the current market assessment. However, the 2.5% dividend yield and the $87.44 price target on the Street will help to upside to my estimates.

In regard to upside, I am optimistic about the company’s acquisition strategy. It recently decided to acquire Miro Technologies, a software producer that will enable  Boeing to better meet customer needs. Organically, however, the company is doing more than "just fine". It came out above analyst expectations in the third quarter so much that annual guidance was raised for yet the third time. Deliveries in both military and commercial lines increased as airlines moved to replace old planes to hedge against rising fuel costs. Commercial airlines, the producer's largest segment, was particularly strong with revenues growing by 17%. This more than offset weakness in the space, security, and defense segments.

United Technologies (NYSE: UTX) & Honeywell (NYSE: HON) Less Attractive

Relative to Boeing, I would avoid United and Honeywell. However, they still have some value in their own right. The former trades at a respective 13.3x and 12.6x past and forward earnings versus corresponding figures of 23.1x and 12.3x for Honeywell. Honeywell is forecasted for 15.2% annual EPS growth over the next 5 years, which is more than 375 bps greater than what is forecasted for United. Honeywell's gross margins are around 500 bps lower than its competitors, so there is also room for operational improvement.

United still has delivered strong results. Earnings have been consistently above expectations over the last three quarters by an average of 18.6% on EPS of $1.37 or higher. During the third quarter, net profit rose 6.9% and was $0.30 per share higher than consensus as synergies realized from the Goodrich integration offset FX headwinds of $0.07 per share. However, management gave a reserved outlook on results hitting the lower end of guidance as a result of a prolonged trough of the commercial aerospace aftermarket.

Honeywell, however, still is my preferred choice. Management just recently hiked their dividend distribution by 10%, but they are still focused on reinvesting money into accretive M&A activity. The company, for example, recently decided to buyout Saia Burgess Control, a maker of programmable controllers in air conditioning systems, for $130 million. Excellent strategic execution has rewarded Honeywell shareholders with nearly a 20% return over the last twelve months and a recent 52-week high. A consistently lower forward PE multiple than the S&P 500, however, may be evidence that the stock lacks exposure to the kind of risk/reward investors are favoring right now. This is likely to change once the economy begins to reverse its sluggish trends.

Fly Home With Additional Information

With great opportunity comes great responsibility. For Boeing, which operates as a major player in a multi-trillion dollar market, the opportunity is absolutely massive. However, the company's execution problems and emerging competitors have investors wondering whether Boeing will live up to its shareholder responsibilities. In this premium research report, two of The Fool's best industrial industry minds have collaborated to provide investors with the key, must know issues around Boeing. They'll be updating the report as key news hits, so make sure to claim a copy today by clicking here now.

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