With concerns about cuts to the defense budget, Boeing (BA) and Lockheed Martin (LMT) are both in a precarious position. In an earlier article (see here), I argued that Boeing had strong fundamentals and was less vulnerable to cuts than what the market acknowledges. This helped drive risk-adjusted returns as the stock appreciated by 12.7% since I first published it here. The S&P 500, during the same time, went up by only 2.6%. Over the last twelve months, aerospace has done well and, in my view, the ideal position now is to be in the sidelines.
From a multiples perspective, LM is the cheaper of the two. It trades at a respective 9.7x and 9.8x past and forward earnings while offering an impressive dividend yield of 5.2%. Boeing, on the other hand, trades at a respective 14.1x and 14.4x past and forward earnings while offering a dividend yield of only 2.4%. The Street currently rates shares of Boeing near a "strong buy" and those of Lockheed more of a "hold". Based on my analysis, Lockheed has meaningfully greater downside and just slightly greater upside.
At the third quarter earnings cll, Boeing's CEO, Jim McNerney, noted positive structural demand despite a challenging business environment:
"Although the global economy has slowed in recent months and uncertainties such as the European sovereign debt crisis remain, we continue to see worldwide expansion in air traffic. Passenger traffic in particular remains resilient, led by trends in emerging markets. Cargo traffic on the other hand has declined in recent months, and that's one area we will watch closely in the months ahead. Despite this mix of signals, strong consumer demand continues for our products and services. For example, through the third quarter, we booked 310 orders for the signle-aisle 737NG, while exceptionally strong twin-aisle demand was led by the 777 with 125 orders across packs".
Recently, as I anticipated here, contracts were signed with Southwest Airlines (LUV), United Arab Emirates' Etihad Airways, and FedEx (FDX). Southwest Airlines purchased 27 new 767-300F Aircraft to modernize its fleet - three will arrive in 2014 and 6 for each of the years between 2015 and 2018. Etihad Airways purchased 150 MAX airplanes known for their fuel efficiency. Etihad Airways purchased 10 Dreamliners and 2 Freighters. The contract announcements arrived close to the same day that Boeing announced it was raising its dividend. Fortunately, the unions have more or less conceded to management and the contract is good until 2016.
Consensus estimates for Boeing's EPS are that it will grow by 0.2% to $4.46 in 2011 and then by 11% and 17% more in the following two years. Assuming a multiple of 16x and a conservative 2012 PS of $4.89, the rough intrinsic value of the stock is $78.24, implying only 10.2% upside. If the multiple were to decline to 14.1x and 2012 EPS turns out to be 4.4% below the consensus at $4.73, the stock would fall by 6.1%.
As for LM: the firm won a major $7.4B F-22 contract with the Air Force. This will alleviate much of investor concerns about sources of funding and could contribute upwards of one-twentieth of 2013 earnings. With that said, LM has several issues at hand that will put downward pressure on the multiples. First, pension costs are higher than many anticipated and could limit buyback activity. Second, the F-35, which was aimed at fueling growth, has proceeded slowly with a long R&D process. Third, budget uncertainty are obviously pushing down revenue projections even more.
Consensus estimates for LM's EPS are that it will grow by 4.5% to $7.59 in 2011 and then by 3.3% and 10.5% more in the following two years. Assuming a multiple of 11x and a conservative 2012 EPS of $7.78, the rough intrinsic value of the stock is $85.58, implying 11% upside. However, if the multiple were to decline to 9x and 2012 EPS turns out to be just 1.9% below the consensus at $7.69, the stock would fall by 10.2%. Accordingly, in agreement with the Street, I recommend holding out for now.