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Recently a survey report took my attention. The report prepared by the Defense Industry Daily explains the results from their latest survey of Top 20 Contractor Assessments. The survey includes a total of 20 companies, 11 of which are publicly traded:

ATK, BAE, Boeing (BA), Computer Sciences (CSC), DRS, EADS, General Atomics, General Dynamics (GD), Harris (HRS), Honeywell (HON), ITT, KBR, L-3 Communications (LLL), Lockheed Martin (LMT), Northrop Grumman (NOC), Raytheon (RTN), Rockwell Collins (COL), SAIC, Thales, and United Technologies (UTX).

The executive summary of the report offers a brief overview of what is inside the full report. The Defense Industry Daily conducted a survey where more than 600 respondents answered several questions. The report explains the perceived strengths and weaknesses of the top defense contractors from the respondents’ perspective. The data is derived from poll conducted in late August 2011. The results give useful insights on contractors’ relative performance in terms of several metrics.


(Click to enlarge) (Taken with Permission From the Defense Industry Daily, report)

The executive report summarizes the survey results as follows:

1. The major U.S. prime contractors are perceived to have a large quality advantage.

2. Aviation-oriented contractors are expected to be very late and over budget.

3. European contractors have a serious perceived performance gap.

4. IT-oriented contractors face low expectations.

5. Device and electronics makers fall into one of two radically divergent sets of perceptions, one positive and one significantly negative.

I am not a big fan of the defense contractors’ business areas, but I think these stocks are among the cheapest industrials. Raytheon, General Dynamics, Lockheed Martin, and Northrop Grumman are among the top dividend stock picks for the next 5 years. Boeing, world’s leading airplane manufacturer is also a cheap stock that has almost 30% upside potential. There are also rumors regarding the acquisition of Goodrich (GR) by United Technologies. Rockwell Collins also surged 7.81% on Friday due to the rumors that Rockwell Collins might be the actual acquisition target. Textron (TXT) also gained 6.76% on the possibility that it might be the real take-over target. You know the rule: Buy the rumor, sell the truth. I think the rumors have some sort of truth.

There are several reports that United Technologies is raising funds for a potential acquisition. While Goodrich is the most likely target, Rockwell Collins and Textron might also be potential takeover candidates. If the rumors are true, I expect around 30% premium for the acquired company. The economies of scale and lower competition will surely benefit both United Technologies and its take-over target. The acquisition will probably boost the share prices of other defense contractors, since investors would realize the premium paid for the acquisition and raise their price targets.

Unfortunately, most ordinary investors do not know which defense contractor would be the next take-over target. You can do a lot of research and try to come up with higher possibility candidates, but still it will be just a wise guess. Instead, long-term investors should look for stocks with low P/E ratios, paying good dividends, and have high- growth prospects. My O-Metrix formula can be one of the tools to be used to choose the stocks for the long-term oriented investors:

O-Metrix = [(Dividend Yield + Growth Estimate) / (P/E Ratio)] * 5

  • Dividend Yield: Higher is better.
  • EPS Growth: Higher is better.
  • P/E Ratio: Lower is better.

The back-testing of this valuation technique on 40 large-caps shows that O-Metrix works very well over the long-term, such as five years. I am also continuously checking on specific sectors, and the formula works very well so far. In this model, dividends are perfect substitutes for earnings growth. I use the average of trailing and forward P/E ratios to smooth the results. Here are the O-Metrix scores of companies mentioned in this article:

Company

P/E

Forward P/E

Dividend Yield

EPS growth next 5 years

O-Metrix Score

Boeing

13.85

12.52

2.57%

11.66%

5.40

Rockwell Collins

14.56

12.49

1.71%

10.01%

4.33

Computer Sciences

6.09

6.2

2.73%

9.00%

9.54

General Dynamics

8.6

7.94

3.10%

8.80%

7.19

Goodrich

17.53

13.46

1.25%

12.47%

4.43

Honeywell Int.

15.06

10.57

2.82%

14.10%

6.60

Harris Corp.

8.85

7.44

2.75%

9.63%

7.60

L-3 Communications

7.85

7.46

2.68%

7.33%

6.54

Lockheed Martin

10.07

8.76

3.95%

9.36%

7.07

Northrop Grumman

8.58

7.64

3.65%

7.94%

7.15

Raytheon Co.

7.86

7.62

4.08%

8.65%

8.22

Textron Inc.

44.36

11.02

0.43%

58.13%

10.57

United Tech.

14.6

12.26

2.54%

12.67%

5.66

Average

13.68

9.64

2.64%

13.83%

6.95

(Data from Finviz, and is current as of Sep. 16 close. You can download O-Metrix calculator, here)

While Textron’s trailing P/E ratio of 44.36 is pretty high, the forward P/E ratio falls to 11.02. Analysts are pretty bullish about the company, estimating an annualized EPS growth of 58.13% for the next 5 years. This number seemed too high to me, but after checking with Morningstar (67%), I was convinced that analysts have really high expectations. Consequently, the stock has the highest O-Metrix score of 10.57.

Nevertheless, I would rather go for low P/E and high-yield stocks with 5+ O-Metrix scores. I think, Raytheon, Northrop Grumman, Lockheed Martin, Computer Sciences, L-3 Communications and General Dynamics offer really good values for the money. Raytheon offers the highest yield of 4.08%, followed by Lockheed Martin (3.95%) and Northrop Grumman (3.65%). They are also priced with single digit P/E ratios. Computer Sciences is not a defense company, but it offers several software services as a defense contractor. The stock lost almost 40% since January, it recently double-bottomed, and is ready for a launch. It is trading with a low P/E ratio of 6.02 and a forward P/E ratio of 6.2, while paying a yield of 2.73%. I think it also offers a deep value for those interested.

The defense stocks have an average O-Metrix score of 6.95, and yield of 2.34%. The average trailing P/E ratio is 13.68, whereas the average forward P/E ratio is 9.64. I think these stocks will continue to be outperformers in the long-run. The take-over rumors will also boost the stock prices as well. You can download the Defense Industry Daily report, here.

Source: Top Defense Companies For The Next 5 Years