This Defense Contractor Is Massively Undervalued

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

Defense contractors are really cheap right now. Investors are concerned that large cuts to the U.S. federal budget will include cuts in defense spending, which would be catastrophic for defense contractors (the U.S. government represents the majority of sales for most of these contractors).

Despite the looming threat of budget cuts, there are several things that the industry has going for it. For instance, Iraq and Afghanistan still require heavy equipment and logistical services that can only be provided by U.S. defense contractors. In addition, Congress is considering allowing contractors to sell a wider array of weapons and weapons systems to allies as conflicts increase around the world.

In addition, new products are coming online that should boost the top line at many of these firms. For instance, unmanned aerial vehicles (drones) are in high demand and are allowed to be sold to U.S. allies. Defense contractors are also cashing in on the federal government's increased cyber-security needs. More products will likely be needed over the coming decade as slow global economic growth leads to increased tension around the globe. Therefore, defense spending should continue to increase despite the rhetoric in Washington.

If you can accept that revenues will continue to increase for defense contractors, then all you need to do is find the cheapest one.

<img src="/media/images/user_13490/defense-pretax_large.png" />

Right now, it looks like Lockheed Martin (NYSE: LMT) is far and away the cheapest company in the industry. At 7.6x normalized pre-tax earnings, the company will have to suffer an enormous drop-off in revenue before investors lose money.

But Lockheed Martin isn't just the cheapest company in the industry, it's also one of the best companies.

<img src="/media/images/user_13490/defense-fcf-margin_large.png" />

Lockheed Martin earns a much more reliable free cash flow margin than Boeing (NYSE: BA), Northrop Grumman (NYSE: NOC), and Raytheon (NYSE: RTN). If you divide the standard deviation of free cash flow margins over the last decade by the average of the margins, you get what statisticians call a coefficient of variation. The lower the coefficient, the less volatility in free cash flow margins. If the margins are stable, then you can safely project similar margins in the future because the business is so predictable.

Lockheed Martin's coefficient of variation is 0.27. By comparison, Boeing's is 0.73, Northrop's is 0.37, and Raytheon's is 0.33. So not only is Lockheed Martin cheaper than its peers, it also appears to be a more predictable company.

Since 2002, Lockheed Martin has averaged a free cash flow margin of 6.06%. If you apply this margin to the trailing four quarters sales of $47.5 billion, you get free cash flow of $2.88 billion. At a 15x multiple of free cash flow, the company is worth $133 per share. At a recent price of $92.63, there appears to be about 44% of upside in Lockheed Martin if it just continues to do the same thing it has always done. If it does better in the future, then the upside is even higher. If it does worse, there's a lot of room for error before it affects investors who buy in at today's low price. So, investors who are bullish on defense contractors should take a close look at Lockheed Martin.

titans8904 has no positions in the stocks mentioned above. 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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