Are Defense Stocks Cheap Enough for the Post-War(s) Era?

Includes: GD, LMT, NOC, RTN
by: YCharts
By Jeff Bailey

Winding down one war in Iraq and determined to bring military action in Afghanistan to an end soon, too, the Obama Administration would seem to be preparing to de-emphasize defense spending and thus send the industry into a tailspin.

A group of four defense stalwarts – Northrop Grumman (NYSE:NOC), General Dynamics (NYSE:GD), Lockheed Martin (NYSE:LMT) and Raytheon (NYSE:RTN) – not surprisingly out-performed the S&P 500 over the last 5 years of global bang-bang.

But anticipating a slowdown in defense spending – one requirement for slowing the growth of government debt — all 4 companies have declined the last 2 years or so.

To the point that they now look kind of cheap. All but General Dynamics have single-digit p/e ratios.

YCharts Pro finds them all undervalued, with Lockheed cheapest, followed by General Dynamics, Northrop and then Raytheon. Boeing (NYSE:BA) looks cheap, too, but it carries both defense-cutback risk and risk from its snake-bitten 787 jetliner program. And its p/e is higher than the others.

Among the four companies, revenue is not tanking.

Dividend yields are decent.

Balance sheets look good, with mostly reduced debt.

And liquidity is fair, based on current account ratios.

Spending on wars will decline, and a few pricey weapons systems may get junked, but much of the large defense contractors’ revenue comes from maintaining old weapons systems, building new ones so that current and future military actions are less lethal to American troops, and providing communications and other technology support to the government. Stuff, in other words, that few Administrations, Republican or Democrat, are inclined to cut deeply.

Northrop, like the others, is the result of multiple acquisitions in recent years, giving it a diversified revenue base ($33.8 billion in 2009), even though Uncle Sam accounts for about 90% of the business. The range of work is mind-boggling: training militaries in Africa for the State Dept.; keeping the ancient B-52 bombers flying; producing major components of the more modern F/A-18 fighter; designing and building a new class of aircraft carriers; work on a space telescope; providing New York City’s wireless network for public safety functions.

Sales for the first nine months of 2010 rose 5% to $26.15 billion, and operating margins widened nicely – to 8.7% from 7.5% of sales. That sent net income up 32% to $1.68 billion, or $5.54 a diluted share. Dividend hikes occur regularly.

Northrop wants to spin off or sell its shipbuilding unit, which despite having a huge backlog of work has struggled to match the returns in other areas.

As taxpayers, it would be super if defense spending could actually decline significantly (beyond the drop we’ll see as two wars cease). But that seems doubtful. In the meantime, these stocks may be worth a look.

Disclosure: No positions