With many of the budget issues conceivably coming to an end and the global economy finally strengthening, the defense biggies are expected to see stability in 2014. The $1.1 trillion Omnibus spending measure President Obama signed into law recently was a big relief for the Pentagon. The bill provides Pentagon with nearly $93 billion to buy weapons and another $63 billion for research and development.
Again, the latest improvement in the U.S. benchmarks with the U.S. Federal Reserve’s confirmation of continued stimulus cut brings some respite to the defense sector. The Fed said it will pare its bond-buying agenda by $10 billion for the second straight month that is expected to trigger optimism with a stronger greenback and softer import costs.
The Aerospace & Defense sector posted a stellar performance in 2013, braving issues like sequestration, budget cuts and cancellation of big-ticket programs. Many sector participants have boosted margins through cost-cutting initiatives, while others have beefed up international sales and focused on high-growth businesses like commercial aircraft that is independent of government spending.
Having said that, the defense sector will still continue to face headwinds as Pentagon’s spending moderates from historical levels. The preeminent defense stocks will however keep their momentum intact by taking good care of their shareholders for years to come.
Three Top Players to Bet On
If given to choose the top three defense stocks, we would suggest Lockheed Martin Corp. (LMT), Northrop Grumman Corp. (NOC) and Alliant Techsystems Inc (ATK).
Lockheed Martin
Pentagon’s foremost contractor Lockheed Martin forecasts higher earnings for 2014 after registering charges related to U.S. defense budget cuts and workforce reduction in the final quarter of 2013. Despite the uncertainties, the company has been able to generate $15.4 billion in orders in the quarter. Foreign orders accounted for 23% of the total orders received and 17% of sales in 2013. This year foreign sales are expected to rise to just lower than 20% of total sales.
Lockheed Martin’s pricey F-35 program emerged largely unhurt in 2013. The fighter jet is expected to gain significant traction in 2014 and 2015. The Omnibus bill backed 68 of the fighter jets over the next two years and also earmarked $333.5 million for the Air Force’s Combat Rescue Helicopter program. The program calls for Lockheed Martin to build 112 new search and rescue helicopters under a joint venture with Sikorsky.
With a $52.17 billion market cap, this Zacks Ranked #2 (Buy) stock trades at 15.4x forward earnings and has a price-to-earnings growth (PEG) ratio of 1.89, which is in line with most other defense stocks. Its current dividend yield is the highest among the top six defense players at 3.27%.
Based on its strong operational performance, analysts expect a solid long-term earnings growth rate of 8.17%. Along with a very attractive price-to-book (P/B) multiple of 10.6 (versus the peer group average of 3.44), Lockheed Martin has a return on equity (ROE) of 186.8% as against its peer group average of 19.4%. The company has registered an 11.4% share price appreciation so far this year.
Northrop Grumman
Although the U.S. Department of Defense (DoD) may be less enthusiastic about big ticket programs these days, Northrop Grumman with support from the Congress has successfully warded off efforts from the Air Force to retire the fleet of Global Hawks. Again, the company stands to gain from the lawmakers’ assurance of the F-35 as it manufactures the AN/APG-81 Radar for the fighter jet. Its aggressive cost-cutting initiatives should pave the way for the achievement of long-term expected earnings growth of 7.71%.
The stock has a PEG ratio of 1.74 and currently sports a Zacks Rank #1 (Strong Buy). It trades at 13.44x forward earnings estimate, a 14.5% discount to the peer group average of 15.7x. It has a current dividend yield of 2.03% and its share price escalated 6.0% since the start of 2014.
Alliant Techsystems
This Zacks Rank #1 (Strong Buy) company delivered robust third quarter fiscal 2014 results driven by its Sporting business. The company witnessed a share price appreciation of around 9.4% so far this year. Alliant Techsystems also boosted its fiscal 2014 top- and bottom-line expectation based on solid fundamentals. The long-term earnings growth for Alliant Techsystems is expected to be more than 12%.
Shares of Alliant are going for about 13.3x the estimate for 2014, a discount to the peer group average of 13.5x.
Bottom Line
The defense pros have been awarded a steady stream of contracts from the Pentagon lately, much to their relief. These companies are also on the lookout for more international contracts, commonly referred to as foreign military sales, to keep their top lines rolling.
Add to this the growing commercial opportunities, thanks to an improving global economy, aging commercial aircraft at most airlines and an inevitable rise in commercial aircraft orders. Defense spending is expected to rise in many foreign countries while technological innovation and acquisition deals strengthen these defense players and lift the overall sector.
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