Defense Contractors: The Best Deal Around?

Includes: BA, GD, HON, LLL, LMT, NOC, RTN
by: Charlie Anderson

The following is an analysis of the major U.S.-based defense contractors.

The Industry:

All of the defense contractors I looked at had goodwill accounting for about 1/3 of assets. This seems odd, but is probably due to the fact that so much revenue comes from the government, so it is possible to carve out a niche and have a significant amount of goodwill.

We must nonetheless consider that this much goodwill can't be taken at face value on the balance sheet when determining financial health. Another con of this industry is the chronically low operating margins, which are around 10% across the industry, probably because of the bargaining power the U.S. government holds in its transactions with these companies.

Despite this, all of the companies I looked at have consistently grown earnings which have translated into solid free cash flow across the board. Another pro of the industry is the predictability of earnings due to multi-year government contracts. Another benefit of dealing with the government is that good companies can develop meaningful, long-term relationships with their main customer.

The Companies:

Boeing (NYSE:BA) is the Goliath in the room, but it isn't a pure play (a fair amount of its revenue comes from the sale of airplanes). Chronic order delays have plagued Boeing, despite having a valuable backlog of orders. Technically and fundamentally it is fairly priced, but not cheap.

Invest if: You trust that Boeing will be able to overcome its logistical problems in airplane manufacturing and thus make its backlog extremely profitable.

Opinion: Personally, I don't like the airline industry. I think that Boeing will continue to be plagued by the logistical nightmare of airplane manufacturing.

Lockheed Martin (NYSE:LMT) and Raytheon (NYSE:RTN) are both huge; however, they are both dependent on the U.S. government for the majority of their revenue. Government contracts have granted both a huge backlog of orders, which ensures some stability. Both also have relatively solid balance sheets. Many measures of value relative to future earnings, like the PEG Ratio, don't account for dividends. Excluding dividends, LMT and RTN don't seem like great values, but their dividends (4.3% and 3.3%, respectively) add a notable margin of safety.

Accounting for these dividends, I think that Lockheed Martin is trading at a 25% discount relative to future earnings, and Raytheon is at around a 40% discount. This would suggest potential returns of 30% and 60%, respectively.

Invest if: You are confident in the U.S. government not significantly cutting defense spending. These are attractively priced, financially healthy, profitable companies.

Opinion: I am considering investing.

Note: I arrived at these three companies after analyzing the top-10 biggest U.S.-based defense contractors, after finding this industry to be one of the cheapest right now.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.