Which Defense Sector Company Makes The Best Investment

| About: Lockheed Martin (LMT)

Summary

This is a study to find a good choice among the defense sector majors.

I chose BA, GD, LMT, NOC and RTN for a comparative study to identify the one on which I can bet for long term.

I ended up liking BA, GD and LMT.

Defense sector companies can remain a relatively safe investment in all business cycles for the inherent reason that global security is always in demand. They may also remain stagnant when government budget allocation is pruned for defense expenses. The last few years are a good example for this scenario. Hence, a comparative study of large companies in the defense sector can show how they have managed the returns to shareholders. I have selected Boeing Co. (NYSE:BA), General Dynamics Corporation (NYSE:GD), Lockheed Martin Corporation (NYSE:LMT), Northrop Grumman Corporation (NYSE:NOC) and Raytheon Company (NYSE:RTN) for the study.

  • BA is the largest commercial aircraft manufacturer in the world. The commercial aircraft manufacturing and providing related services can help them grow their revenue from a diversified source reducing dependence on government source.
  • GD has four major divisions - Aerospace (Gulfstream and Jet Aviation), Combat Systems, Information Systems and Technology and Marine Systems. Their marine system is capable of designing, building and servicing nuclear-powered submarines (only one of two in the world).
  • LMT is the largest defense contractor in the world. LMT purchased Black Hawk helicopter maker Sikorsky Aircraft from United Technologies (NYSE:UTX) for $9 billion in cash. This will help improve the revenue growth and EPS going forward.
  • LMT agreed to separate its IS&GS division and combine it with Leidos in a Reverse Morris Transaction. The transaction is valued at about $5 billion and is likely to get completed in this year. LMT's shareholders will receive 50.5% of the equity value of Leidos valued at $3.2 billion. LMT will receive a one-time cash payment of $1.8 billion, which it will use to pay debts, dividends and buy back shares.
  • NOC has Aerospace Systems, Mission Systems and Technology Services.
  • RTN has four major business divisions - Integrated Defense Systems, Intelligence, Information and Services, Missile Systems, Space and Airborne Systems. RTN is significantly growing their foreign military business. This makes it less reliant on the US defense budget.
  • I am using historical data gathered from Morningstar.com Or Yahoo Finance Or Google Finance for my study.
  • As defense contractors, the growth depends on government budget allocation for defense spending. With growing global insecurity, the budget allocation cannot remain at the reduced levels for more years.
  1. Market Cap. :
    BA GD LMT NOC RTN 20-Jul-16
    CMP 134.66 143.31 258.96 221.55 137.97
    Market Cap (Billions) 86.45 43.47 78.63 39.86 40.78
    Click to enlarge
    The market cap is reasonably large for all these companies and I am comfortable to invest in any of these for the long term.
  2. The historical revenue data for the past 10 years is given below:
    Revenue (Millions) BA GD LMT NOC RTN
    2006 61,530 24,063 39,620 30,148 20,291
    2007 66,387 27,240 41,862 32,018 21,301
    2008 60,909 29,300 42,731 33,887 23,174
    2009 68,281 31,981 45,189 33,755 24,881
    2010 64,306 32,466 45,803 34,757 25,183
    2011 68,735 32,677 46,499 26,412 24,857
    2012 81,698 31,513 47,182 25,218 24,414
    2013 86,623 31,218 45,358 24,661 23,706
    2014 90,762 30,852 45,600 23,979 22,826
    2015 96,114 31,469 46,132 23,526 23,247
    TTM 96,597 31,409 47,723 23,525 23,722
    CAGR 3yrs 5.57% -0.75% -2.29% -1.62%
    CAGR 5yrs 8.37% -0.62% 0.14% -7.51% -1.59%
    CAGR 9yrs 5.08% 3.03% 1.71% -2.72% 1.52%
    Absolute in 9 Years 56.21% 30.78% 16.44% -21.96% 14.57%
    Click to enlarge
    BA has an impressive revenue growth. The best three are BA, GD and LMT in that order.
  3. The historical gross margin %:
    Gross Margins % BA GD LMT NOC RTN
    2006 18.00 10.90 8.70 18.20 18.40
    2007 19.60 11.40 10.10 19.40 20.00
    2008 17.30 12.50 10.90 18.30 20.10
    2009 17.20 17.60 9.30 16.70 20.60
    2010 19.40 18.20 8.40 17.70 19.40
    2011 18.70 17.90 8.00 21.30 20.80
    2012 16.00 16.20 8.90 22.10 21.80
    2013 15.40 18.50 9.20 21.80 21.80
    2014 15.40 19.00 11.50 23.40 24.20
    2015 14.60 19.50 11.30 24.00 24.40
    TTM 14.40 19.50 10.80 23.90 23.50
    10 Years Max % 19.60% 19.50% 11.50% 24.00% 24.40%
    10 Years Min % 14.40% 10.90% 8.00% 16.70% 18.40%
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    NOC and RTN have an impressive gross margin %. NOC and RTN had comparable growth in gross margin %. GD's margin growth is impressive and is catching up with those of NOC and RTN. LMT's margin expansion is limited while that of BA's is contracting. Considering BA's revenue growth, the margin contraction is acceptable. It is important to see if the margin expansions have percolated into their net income.
  4. The historical net income:
    Net Income (Millions) BA GD LMT NOC RTN
    2006 2,215 1,856 2,529 1,542 1,283
    2007 4,074 2,072 3,033 1,790 2,578
    2008 2,672 2,459 3,217 -1,262 1,672
    2009 1,312 2,394 3,024 1,686 1,935
    2010 3,307 2,624 2,926 2,053 1,840
    2011 4,018 2,526 2,655 2,118 1,866
    2012 3,900 -332 2,745 1,978 1,888
    2013 4,585 2,357 2,981 1,952 1,996
    2014 5,446 2,533 3,614 2,069 2,244
    2015 5,176 2,965 3,605 1,990 2,074
    TTM 5,059 2,966 3,521 2,062 1,952
    CAGR 3yrs 9.89% 5.49% 9.51% 0.20% 3.18%
    CAGR 5yrs 9.37% 2.47% 4.26% -0.62% 2.42%
    CAGR 9yrs 9.89% 5.34% 4.02% 2.87% 5.48%
    Absolute in 9 years 133.68% 59.75% 42.55% 29.05% 61.65%
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    BA's net income expansion is impressive. GD and LMT managed to grow their net income reasonably. NOC and RTN seem to hover around their 2009/10 levels only. Though NOC and RTN had an impressive gross margin %, their inability to grow their revenue resulted in poor net income results. Again, my choice is BA, GD and LMT.
  5. The historical net margin %:
    Net Margins % BA GD LMT NOC RTN
    2006 3.60 7.71 6.38 5.11 6.32
    2007 6.14 7.61 7.25 5.59 12.10
    2008 4.39 8.39 7.53 -3.72 7.22
    2009 1.92 7.49 6.69 4.99 7.78
    2010 5.14 8.08 6.39 5.91 7.31
    2011 5.85 7.73 5.71 8.02 7.51
    2012 4.77 -1.05 5.82 7.84 7.73
    2013 5.29 7.55 6.57 7.92 8.42
    2014 5.99 8.21 7.93 8.63 9.83
    2015 5.38 9.42 7.81 8.46 8.92
    TTM 5.23 9.44 7.38 8.77 8.23
    10 Years Max % 6.14% 9.44% 7.93% 8.77% 12.10%
    10 Years Min % 1.92% 7.49% 5.71% 4.99% 6.32%
    Click to enlarge
    I have ignored GD's 2012 year in reporting the 10-year minimum %, since they had unusual expenses leading to negative net income. The same way, I have ignored NOC's negative net income for the year 2008. I prefer a minimum net income of 10% for an investment selection, which is not the case with any of these companies.
  6. How the companies managed the outstanding shares?
    Shares (Millions) BA GD LMT NOC RTN
    2006 788 407 436 359 451
    2007 773 408 427 354 446
    2008 729 399 409 335 423
    2009 713 388 388 323 395
    2010 744 385 368 301 377
    2011 753 368 339 282 354
    2012 762 353 328 253 334
    2013 768 353 327 234 324
    2014 737 341 322 212 313
    2015 695 327 314 191 305
    Now = Mkt.Cap from Google Finance / CMP 642 303 304 180 296
    Reduction % (Avg 3-Yr) 6.15% 5.19% 2.50% 9.16% 3.11%
    Reduction % (Avg 5-Yr) 3.24% 3.94% 2.23% 9.40% 3.67%
    Reduction % (Avg 9-Yr) 2.07% 2.98% 3.68% 7.15% 4.32%
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    The share buybacks by NOC and RTN are in excess of their peers LMT and GD.
  7. How does the net income reflect on a per share basis?
    Earnings Per Share BA GD LMT NOC RTN
    2006 2.85 4.56 5.80 4.37 2.85
    2007 5.28 5.08 7.10 5.12 5.79
    2008 3.67 6.17 7.86 -3.77 3.95
    2009 1.84 6.17 7.78 5.21 4.89
    2010 4.45 6.81 7.94 6.82 4.88
    2011 5.34 6.87 7.81 7.52 5.28
    2012 5.11 -0.94 8.36 7.81 5.65
    2013 5.96 6.67 9.13 8.35 6.16
    2014 7.38 7.42 11.21 9.75 7.18
    2015 7.44 9.08 11.46 10.39 6.80
    TTM 7.40 9.24 11.30 11.01 6.44
    Analysts Estimate Current Year 8.50 9.52 11.84 10.71 7.18
    Analysts Estimate Next Year 9.53 10.04 13.79 12.03 7.97
    CAGR 3yrs 13.34% 11.09% 9.98% 6.37%
    CAGR 5yrs 10.83% 5.92% 7.62% 8.78% 6.86%
    CAGR 9yrs 11.25% 7.95% 7.86% 10.10% 10.14%
    Click to enlarge
    LMT and GD have consistent EPS growth. If we simply calculate point to point, all the companies showed growth. My choice here is LMT and GD in that order. GD had unusual expenses in the year 2012 leading to negative EPS, which I have ignored.
  8. The historical Dividend per share:
    Dividend Per Share BA GD LMT NOC RTN
    2006 1.20 0.89 1.25 1.16 0.96
    2007 1.40 1.10 1.47 1.48 1.02
    2008 1.60 1.34 1.83 1.57 1.12
    2009 1.68 1.49 2.34 1.69 1.24
    2010 1.68 1.64 2.64 1.84 1.50
    2011 1.68 1.83 3.25 1.97 1.72
    2012 1.76 2.51 4.15 2.15 2.00
    2013 1.94 1.68 4.78 2.38 2.20
    2014 2.92 2.42 5.49 2.71 2.42
    2015 3.64 2.69 6.15 3.10 2.68
    TTM 3.82 3.52 6.30 3.20 2.74
    Previous 3-Yr Growth 27.41% 2.34% 14.01% 12.97% 10.25%
    Previous 5-Yr Growth 16.72% 10.40% 18.43% 11.00% 12.31%
    Previous 9-Yr Growth 13.12% 13.08% 19.37% 11.54% 12.08%
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    The above data is taken from Morningstar.com. Since the dividend dates in some cases moved the quarterly dividend date to the next year, the above data is not comparable as such. Hence, I have reconstructed the above data based on the 4x maximum number of identical quarterly dividends paid in each year. This will make the dividend growth study comparable.
    Dividend Per Share BA GD LMT NOC RTN
    2006 1.20 0.92 1.20 1.04 0.96
    2007 1.40 1.16 1.40 1.27 1.02
    2008 1.60 1.40 1.68 1.48 1.12
    2009 1.68 1.52 2.28 1.60 1.24
    2010 1.68 1.68 2.52 1.72 1.50
    2011 1.68 1.88 3.00 1.88 1.72
    2012 1.76 2.04 4.00 2.20 2.00
    2013 1.94 2.24 4.60 2.44 2.20
    2014 2.92 2.48 5.32 2.80 2.42
    2015 3.64 2.76 6.00 3.20 2.68
    2016 = 4 x Last Div. 4.36 3.04 6.60 3.60 2.93
    Previous 3-Yr Growth 30.99% 10.72% 12.79% 13.84% 10.02%
    Previous 5-Yr Growth 21.01% 10.09% 17.08% 13.88% 11.24%
    Previous 9-Yr Growth 13.77% 12.70% 18.59% 13.22% 11.80%
    Current Dividend Yield 3.24% 2.12% 2.55% 1.62% 2.12%
    Click to enlarge
    LMT has grown its dividend payments impressively. BA substantially improved its dividend payout in the last 2 years to catch up for its stagnant earlier payouts. Overall, all the companies increased their dividend payout satisfactorily.
  9. How does the dividend payout compare to the free cash flow generated?
    Free Cash Flow per Share BA GD LMT NOC RTN
    2006 7.44 4.72 5.82 3.81 4.50
    2007 10.17 6.01 7.73 6.22 1.80
    2008 -3.09 6.57 8.53 7.56 3.86
    2009 6.19 6.33 5.97 4.36 6.01
    2010 2.45 6.79 7.40 5.57 4.13
    2011 0.89 5.91 6.69 4.76 3.42
    2012 7.61 6.33 1.88 9.11 4.61
    2013 11.74 5.40 4.20 8.43 5.86
    2014 3.87 13.99 12.98 8.45 6.44
    2015 12.39 4.70 8.34 7.17 6.53
    Last Div./EPS % 58.92% 32.90% 58.41% 32.70% 45.50%
    Last Div./CashFlow % 35.19% 64.68% 79.14% 50.21% 44.87%
    Click to enlarge
    BA's uneven free cash flow generation is acceptable when read with their revenue growth. NOC and RTN are more steady in their cash generation. In all cases, the dividend payout is less than 60% of their respective EPS. GD and NOC have paid about a 3rd of their EPS as dividends and so can comfortably increase their dividend for many years to come. Based on EPS, all companies can be expected to keep increasing their dividends year after year. None of the companies resorted to paying dividends in excess of their free cash flow.
  10. The historical debt/equity ratio:
    Debt / Equity Ratio BA GD LMT NOC RTN
    2006 1.72 0.28 0.64 0.24 0.30
    2007 0.82 0.18 0.44 0.22 0.18
    2008 0.31 1.24 0.29 0.25
    2009 5.74 0.25 1.22 0.33 0.23
    2010 4.15 0.18 1.35 0.30 0.37
    2011 2.85 0.30 6.45 0.38 0.56
    2012 1.53 0.34 157.90 0.41 0.59
    2013 0.54 0.27 1.25 0.56 0.42
    2014 0.94 0.29 1.81 0.82 0.56
    2015 1.38 0.27 4.61 1.16 0.53
    Click to enlarge
    I am relatively more comfortable with the debt/equity ratio of GD and RTN. If the interest rates start to go up, GD will face lesser impact compared to others.
  11. The current market price of any share is always futuristic with optimism and pessimism driving it. The high and low prices of any year are based on the EPS expected going forward. If this is true, using the EPS expectations of next year along with a year's high/low is more ideal rather comparing the traditional P/E multiples. I do not have historical EPS expectation data for these companies. However, I can compare each year's high/low prices along with the next year's EPS to arrive at a reasonable earnings multiples for any company (let me call it the forward P/E multiples). The EPS guidance then can be used along with these high/low multiples to project an exit/entry price.
    Forward P/E Multiples BA GD LMT NOC RTN
    2013 High 19.24 14.36 16.43 13.91 14.84
    Low 9.85 9.67 9.41 7.69 8.48
    2014 High 19.43 19.69 17.73 15.71 15.53
    Low 15.63 12.65 12.91 11.20 12.21
    2015 High 18.69 16.93 19.89 18.67 19.12
    Low 13.55 14.42 15.87 13.63 14.02
    Highest of Multiples 19.43 19.69 19.89 18.67 19.12
    Average of Above 16.06 14.62 15.37 13.47 14.03
    Lowest of Multiples 9.85 9.67 9.41 7.69 8.48
    Price Projection BA GD LMT NOC RTN
    EPS - TTM 7.40 9.24 11.30 11.01 6.44
    EPS Estimate - Current Year 8.50 9.52 11.84 10.71 7.18
    EPS Estimate - Next Year 9.53 10.04 13.79 12.03 7.97
    CMP 20-Jul-16 134.66 143.31 258.96 221.55 137.97
    Target to exit at 20 x Next year EPS (See disclosure below) 190.60 200.80 275.80 240.60 159.40
    Entry price limit at 15 x Next year EPS (Max price I would pay in a bullish market) (See disclosure below) 142.95 150.60 206.85 180.45 119.55
    Entry price limit at 13 x Next year EPS (My comfortable entry limit) (See disclosure below) 123.89 130.52 179.27 156.39 103.61
    Click to enlarge
    I believe that a fear syndrome can drive the prices down to the lowest multiples level; it is not possible to make a buy exactly at those levels. Waiting for that level may not happen. Quite often, the price on a given date will appear high, while the same will become a 52-week low with passing of time and release of new quarterly data where the expectations are met. Hence, the exercise is done only to ensure that I am in the safe zone and that the current price multiples in terms of expected EPS is reasonable. Generally, a 14 to 15 multiples or below is an entry point for a safe investment and 20 is an exit multiple. So I have projected my guidance price for the scripts as shown in the table. These are my personal comfortable earnings multiples.

Conclusion

For those who invest based on revenue growth, BA seems a good choice. For those who believe in value investing, GD seems a better choice. Those who believe in dividend growth might like LMT. I like BA, GD and LMT.

Please note that this analysis is made just before the quarterly results update for all the above companies. LMT released their quarterly update yesterday, after my preparation of this article and the results are impressive. It is likely that their future guidance could change my exit and entry prices.

Disclaimer: I am long in LMT for over two years. I was wondering, if I should continue holding it or exit before making this analysis. Now I am convinced to hold it. I picked GD recently for the short term and now I intend holding some part of it for the long term.

Additional Disclosure and Caution: The target prices for entry or exit is my personal view. I do not want anyone to depend on this. I am not an investment advisor. I am not responsible to anyone for using this article or adapt this article for finding target prices. This is not a recommendation to buy or sell any of the shares mentioned.

Disclosure: I am/we are long LMT, GD.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.