The year 2014 has been a dynamic one for the defense sector – sequestration and cancellation of big ticket items did not do as much damage as was earlier apprehended. Thanks go largely to a rebounding U.S. economy.
The year was also marked by geopolitical tensions, particularly the emergence of the cannibalistic Islamic State (“IS”), an extreme jihadist movement fighting against governments in Iraq and Syria, which drew the U.S. into increasing involvement. The Republican win and the resignation of Defense Secretary Chuck Hagel in the latter half of the year had important ramifications for the defense sector,
Defense Spending and Economic Growth: The U.S. economy is on a robust growth trajectory with the strongest two consecutive quarters of growth in more than a decade. The economy expanded at a solid clip of 3.9% annually in the third quarter, up from the initial estimate of 3.5%, and was preceded by 4.6% growth in the second quarter.
The third-quarter 2014 results for the aerospace and defense sector were solid in terms of beat ratios (percentage of companies coming out with positive surprises). The earnings "beat ratio" was 88.9%, while the revenue "beat ratio" was 55.6% (Rebounding US Economy to Breathe New Life into Defense?).
The defense sector has so far handled the budget austerity with strong operational proficiency, boosting margins and profitability on the back of technological progress, accretive acquisitions and cost-cutting efforts of individual companies.
Brewing Violence Spurs Defense: Rising geopolitical tensions have pushed up demand for U.S. weapons exports to an all-time high, eventually benefiting the domestic defense manufactures. As the U.S.-led airstrikes in Iraq and Syria against the IS continue and the U.S. administration pledges to engage in a long-term and more proactive intervention in Iraq, the U.S. defense companies have seen a spurt in federal spending on defense. Following the strikes in Syria on Sep 23, shares of Lockheed Martin Corp. (LMT), Northrop Grumman Corp. (NOC), Raytheon Co. (RTN) and General Dynamics Corp. (GD) hit record prices.
Chuck Hagel Resignation & Republican Win: The emergence of the IS this year, the administration’s slow response to the rising threat, its nuclear negotiations with Iran, hesitant reaction to Russian aggression in Ukraine as well as a threatened Ebola epidemic in Africa raised some uneasy questions.
The resignation of Hagel marked the first major change in Obama’s Cabinet since his Democrats were beaten hollow in midterm elections in Nov 2014. The exit of Chuck Hagel was triggered by national security challenges and a revision of the Afghanistan exit plan which pressed the President to shake up its security staff. Hagel’s antiwar contour seemed to be less valuable when the government was increasingly inclined on a war footing.
No Wishing Away Sequestration: Budget austerities still remain an overhang on the military sector hitting the top lines of the heavy weights in the sector. The Budget Control Act passed in 2011 capped both domestic and defense discretionary spending through the end of the decade, imposing a disproportionate burden on weapons accounts. The Obama Administration announced the cancellation of numerous weapons programs.
In this backdrop, let us have a look at the stocks that have performed proficiently over the year that was. It was no mean feat as they had to constantly combat budget issues. The stock selection is based on year-to-date share price return and a healthy earnings surprise history. These stocks have not only outperformed in 2014 but also appear to be well positioned to benefit from the sector dynamics going into the New Year.
General Dynamics Corp.: Headquartered in Falls Church, VA, the company offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; shipbuilding; and communication and information technology systems and solutions.
The company’s shares gained 46.34% so far this year – the highest among the pure-play defense majors. The company currently carries a Zacks Rank #2 (Buy) and has a solid earnings surprise trajectory beating the Zacks Consensus Estimate by an average 7% in the trailing seven quarters.
It has a forward price-to-earnings ratio (P/E) of 18.09x. Return on equity (ROE) stands at 18.8%, a little above the peer group average of 18.5%.
Northrop Grumman Corp.: The company has a strong presence in the Air Force as well as Space & Cyber Security programs. Revenue and earnings growth continue to be driven by its wide presence in the current focus areas of cyber security, modernization of defense and homeland security assets, intelligence, surveillance and reconnaissance (“ISR”) systems, advanced electronics and software development.
This $30.28-billion-market-cap-defense company posted an average earnings surprise of 7.5% in six out of the last seven quarters. Northrop Grumman has an impressive share price return of 30.79% so far this year.
Its forward P/E is 15.81x and ROE stands at 18.2%.
Lockheed Martin Corp.: The leading defense contractor of the nation has an impressive earnings surprise history beating the Street consensus in the last seven quarters with an average beat ratio of 15.6%. With a market cap of $60.55 billion, its shares gained 29.73% so far this year.
The forward P/E is 17.24. ROE is at an impressive 76.5% as compared to the peer group average of 18.5%.
Bottom Line
Needless to say the defense industry – at the forefront of the country’s protection and security – gains during times of war and conflict. This is borne out by the performance of defense stocks during the first Gulf War as well as the conflict with the Taliban in Afghanistan following the 9/11 attacks.
Moreover, continuing skirmishes against adversaries in Iraq and Syria are expected to boost the defense stocks mentioned above in the quarters ahead.
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