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Defense Stocks: Crushing the Market, Room to Run

One of the more surprising mistakes among market forecasters last year was the widespread dismissal of major defense contractors. The companies themselves were predicting massive revenue losses ahead of government’s automatic spending cuts, and a lot of official stock pickers preferred to ignore, if not necessarily diss, major defense company prospects in such a changing environment.

Nearly ten months into 2013, sequestration issues drag on and defense company revenues are stagnant at best. But there are reasons to suspect that these companies will end up on a few more “stocks for the new year” lists in December than they did in 2012.

So far this year, big defense companies report some of the best returns among large-cap stocks. Shares of Honeywell International (HON), Raytheon (RTN), Lockheed Martin (LMT), Northrop Grumman (NOC) and General Dynamics (GD) are each up at least 28% year-to-date, compared to an S&P 500 gain of 19%. And no, those gains do not appear dependent on threats to bomb Syria.

HON Chart

HON data by YCharts

Include dividends for these companies, using total return price, and most have racked up 35% or bigger gains for the year.

HON Total Return Price Chart

HON Total Return Price data by YCharts

Sequestration has already cut these companies’ business to some extent, and as expected, the sector’s dull revenue growth has gotten worse. Revenues are pretty flat throughout.

HON Revenue Quarterly YoY Growth Chart

HON Revenue Quarterly YoY Growth data by YCharts

Earnings and forecasts, however, have come in higher than expected. That’s partly because of more upside from cost cutting efforts than forecast. In recent years, all of these companies cut employee counts drastically and pension costs too, and that has done unexpected wonders for profits even as sales slid. Lockheed, for example, reported earnings per share up 11% at last quarter even with a 4% revenue decline. Revenues are expected to decline further this year and in 2014 too, but the mean forecast for EPS year-end 2014 ($9.48) is 12% higher than 2012 EPS. Long-term, analysts expect earnings growth for all of these companies, sequester or not.

LMT EBITDA TTM Chart

LMT EBITDA TTM data by YCharts

The rising productivity of these companies can be seen in revenue per employee figures.

HON Annual Revenue Per Employee Chart

HON Annual Revenue Per Employee data by YCharts

The big draw to defense contractors lately may have more to do with their cred as cheap industrial stocks. Industrial stocks have become a popular pick among gurus this year as they watch economies around the world recover, making them more capable of paying for big, expensive machinery. In fact, the defense companies have been turning some surprisingly strong sales in parts of their books not dependent on the U.S. Department of Defense. For example: Raytheon’s international sales rose 10% last quarter over the comparable period. General Dynamics, which makes Gulfstream private jets, reported a 29% gain in aerospace revenues. Honeywell also is in the recovering aerospace market, as well as in relatively strong automotive markets.

And Scanning the YCharts Stock Screener for industrials over $10 billion in market cap, we see few U.S. companies cheaper on a forward price-to-earnings ratio than Northrop, Lockheed and General Dynamics.

HON Forward PE Ratio Chart

HON Forward PE Ratio data by YCharts

Although some have wondered if the defense industry overhyped the harm sequestration would do – it was, after all, building a worst-case scenario to impress Congress, not shareholders – there are also concerns that the full effects won’t hit their financials for a couple of years. The uncertainty keeps the sector covered in a wash of hold ratings from analysts. Of our five here, only Honeywell gets a strong buy recommendation. Honeywell has crushed General Electric (GE).

Meanwhile, though, the companies are doing what good industrial investments do in tough times: showering shareholders in dividend hikes and share repurchases. They all generate plenty of cash flow to continue the generosity. Perhaps that’s enough to make investors forget about U.S. budget cuts for now.

HON Cash Ratio Chart

HON Cash Ratio data by YCharts

Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at editor@ycharts.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.

Read more articles about: Company Analysis  defense stocks   stocks that look cheap   

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