How To Benefit From Ballistic Defense Stocks

| About: Lockheed Martin (LMT)

Summary

Leading defense companies have appreciated tremendously since 2012.

Defense orders are likely to increase in the next two years, irrespective of the results of the upcoming U.S. presidential election.

Valuations are expensive, and we favor an option position to capitalize on a move in either direction.

Since the end of 2012, the prices of four leading defense stocks have gone ballistic. The market capitalization of a hypothetical basket of four leading defense stocks comprised of Northrop Grumman Corporation (NYSE:NOC), Lockheed Martin Corporation (NYSE:LMT), Raytheon Company (NYSE:RTN) and General Dynamics (NYSE:GD) has increased by over 124.5% from about $91.3 billion in 2012 to $204.9 billion as of 8/5/2016. That's an average increase of over 34.6% annually on a non-compounded basis (25.2% compounded).

Leading defense stocks market capitalization 2012 to 2016 - Source: Y-Charts

Leading defense companies stock price 1995 to 2016 - Source:Y-Charts

Such impressive performance has materialized despite president Obama's generally pacifist stance, whereby the U.S.A. has refrained from engaging in troops-led military conflicts during the past 8 years. On the other hand, local/regional conflicts mushroomed in multiple countries including Syria, Iraq, Libya and Ukraine, opening the door for targeted equipment-led responses from the U.S.A. The global fight against ISIS has created increased demand for high-tech precision weaponry, while international conflicts and instability have provided U.S. defense companies an opportunity to grow international defense sales. As underlined by Zacks Equity Research:

The big defense operators are expanding their markets, with foreign sales acting as a key top-line growth driver. Driving the demand for foreign sales is a number of escalating regional conflicts, such as, the ongoing Syrian civil war, the unsettled situation in Iraq, Yemen and Libya, and tensions in Eastern Europe. Apart from the U.S., U.K. or France, a number of emerging markets as well as nations, such as, India, Japan, the United Arab Emirates, Saudi Arabia and Brazil are increasing defense spending and generating business for the U.S. aerospace and defense companies.

Irrespective of the outcome of the November presidential elections in the U.S.A., the war on terror is unlikely to end anytime soon. Furthermore, both candidates, Hillary Clinton and Donald Trump, are likely to pursue a Middle East policy that requires higher engagement from the U.S.A. than has been pursued by president Obama, with a real possibility of ground troops. As reported by Politico in March 2016:

Donald Trump would deploy up to 30,000 American soldiers in the Middle East to defeat the Islamic State, he said at Thursday night's debate.

Likewise, as reported by the Guardian, Hilary Clinton stated in November 2015:

"The United States has been conducting this fight for more than a year; it's time to be begin a new phase and intensify and broaden our efforts," Clinton told the Council on Foreign Relations in New York.

"We should have no illusions about how difficult the mission before us really is … but if we press forward on both sides of the border, in the air on the ground and as well as diplomatically, I do believe we can crush Isis's enclave of terror," she added.

From a short term perspective, for the next 18 months, global turmoil is likely to provide additional demand for U.S. defense companies' products. In case the next U.S. president does increase U.S. engagement with the objective of securing 'victory' & restoring global stability, and in case such 'victory' is secured, then any short term surge in defense related demand may prove to be short-lived if global stability is indeed restored. On the other hand, some may also argue that maintaining such stability would require the U.S. to continue beefing up its defense capabilities. As summarized by Morningstar analyst Chris Higgens on CNBC:

"If you look at the defense spending cycle, we're at a cyclical bottom basically," he said.

Back in 2009, the fiscal deficit was running almost 10 percent of gross domestic product, and it fell to roughly 8 percent in 2010-2011, Higgins said. More recently, though, was at around 2 to 3 percent of GDP.

"The four factors that we look at are all flashing green for defense spending to go upwards," Higgins said. "When you think about those factors, regardless of who is elected president we argue that we are at the cusp of an increase in defense spending."

Given the preceding, at least for the next few years, it does seem that the global environment is quite supportive for defense spending. However, leading defense stocks have already appreciated noticeably; such expectations may already be factored into their current stock prices, and may have rendered valuations too expensive. As per below graphs, forward P/E and P/S ratios are running at levels which are as much as double to triple their 2012 levels.

Forward P/E ratios for leading defense stocks from 2011 to 2016 - Source: Y-Charts

Forward P/S ratios for leading defense stocks from 2012 to 2016 - Source: Y-Charts

The combination of high valuations, global uncertainty, a favorable defense spending environment and the upcoming U.S. elections is likely to act as a catalyst for continued substantial moves in the prices of the above leading defense stocks. However, due to high valuations, we do believe such moves could be in either direction, and hence, we would favor an option strategy.

Northrop Grumman Corporation

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Northrop shares 10-year price chart - Source: Yahoo Finance

Northrop has appreciated by about 224% from 67.58 (dividend adjusted) on 12/31/2012 to 218.95 on 8/5/2016, an average of 62.2% annually on a non-compounded basis (38.7% on a compounded basis). With average analysts' earnings estimates of $11.02/share for this year and 11.74/share for next year, Northrop's forward P/E ratios stand at 19.87 and 18.65 respectively. During the last 13 years, Northrop's P/E ratio (TTM) has ranged between 6.85 and 19.94, with a median of about 13.48. Given such elevated valuation, although Northrop can trade higher on defense demand optimism, the shares are also quite vulnerable to the downside.

We favor buying calls expiring February 17, 2017 with a strike of 230 currently trading for a premium of about 6.00, and corresponding puts with a strike of 200 currently trading for a premium of about 6.00. We would be inclined to buy two puts for each call, due to elevated valuations. Break-even is about 248 to the upside and 191 to the downside.

Lockheed Martin Corporation

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Lockheed Martin shares 10-year price chart - Source: Yahoo Finance

Lockheed Martin has appreciated by 182.3% from 92.29 on 12/31/2012 to 260.29 on 8/5/2016, an average of 50.6% annually on a non-compounded basis (33.4% on a compounded basis). With average analysts' earnings estimates of $12.51/share for this year and $12.90/share for next year, Lockheed Martin's forward P/E ratios stand at 20.8 and 20.2 respectively. During the last 13 years, Lockheed Martin's P/E ratio has ranged between 7.55 and 22.34, with a median of about 14.37.

Investors have driven Lockheed Martin's valuations to such extreme as the company is in a position to benefit particularly well from continued global political turmoil. As stated by Mother Jones:

As Lockheed Martin's Marillyn Hewson noted, however, the Middle East is hardly the only growth area for that firm or others like it. The dispute between China and its neighbors over the control of the South China Sea (in many ways an incipient conflict over whether that country or the United States will control that part of the Pacific Ocean) has opened up new vistas when it comes to the sale of American warships and other military equipment to Washington's East Asian allies. The recent Hague court decision rejecting Chinese claims to those waters (and the Chinese rejection of it) is only likely to increase the pace of arms buying in the region.

At the same time, in the good-news-never-ends department, growing fears of North Korea's nuclear program have stoked a demand for US-supplied missile defense systems. The South Koreans have, in fact, just agreed to deploy Lockheed Martin's THAAD anti-missile system. In addition, the Obama administration's decision to end the longstanding embargo on US arms sales to Vietnam is likely to open yet another significant market for US firms. In the past two years alone, the US has offered more than $15 billion worth of weaponry to allies in East Asia, with Taiwan, Japan, and South Korea accounting for the bulk of the sales.

Despite such business outlook optimism, although Lockheed Martin shares can appreciate further due to global military turmoil, the shares are also quite vulnerable to the downside due to record valuations. We favor buying calls expiring March 17, 2017 with a strike of 265 currently trading for a premium of about 7.20, and corresponding puts with a strike of 230 currently trading for a premium of about 6.90. Again would be inclined to buy two puts for each call, due to elevated valuations. Break-even is about 286 to the upside and 219.5 to the downside.

Raytheon Company

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Raytheon shares 10-year price chart - Source: Yahoo Finance

Raytheon Company has appreciated by over 144.5% from 57.56 on 12/31/2012 to 140.76 on 8/5/2016, an average of 40.2% annually on a non-compounded basis (28.2% on a compounded basis). Consensus earnings estimates of $7.41/share for this year and $7.77/share for next year, Raytheon's forward P/E ratios stand at 19.0 and 18.1 respectively. During the last 13 years, Raytheon's P/E ratio has ranged between 7.28 and 22.64, with a median of about 12.09.

Raytheon's international business is quite healthy, with substantial order backlog. It is estimated that 42% of Raytheon's order backlog is from international sales. As noted by Zacks Equity Research:

In this regard, it is worth mentioning that foreign military contracts are a vital growth driver for Raytheon Company too. The company has been witnessing a steady rise in international sales over the past few years. International bookings comprised 31% of total company bookings in the second quarter of 2016. International sales increased 8% in the quarter while 42% of the total backlog was from international customers. Rising demand from the Gulf countries as well as the Asia-Pacific region will likely be the company's primary revenue driver.

Once again, on one hand, Raytheon's prospects look promising due to geopolitical instability, while on the other hand, valuations are quite expensive and may have gone too far. Such divergence could be a recipe for a substantial move in Raytheon's shares to either direction. We favor buying calls expiring February 17, 2017 with a strike of 145 currently trading for a premium of about 4.75, and corresponding puts with a strike of 135 currently trading for a premium of about 5.45. Again would be inclined to buy two puts for each call, due to elevated valuations. Break-even is about 160.65 to the upside and 127.17 to the downside.

General Dynamics

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General Dynamic shares 10-year price chart - Source: Yahoo Finance

General Dynamics has appreciated by over 114.9% from 69.27 on 12/31/2012 to 148.89 on 8/5/2016, an average of about 32% annually on a non-compounded basis (23.7% on a compounded basis). Consensus earnings estimates of $9.71/share for this year and $10.03/share for next year, General Dynamic's forward P/E ratios stand at 15.3 and 14.8 respectively. During the last 13 years, General Dynamic's P/E ratio has ranged between 5.80 and 21.53, with a median of about 14.95.

General Dynamics' future business prospects also look very positive if it is able to win additional future defense contracts. As reported by CNBC:

Also, the U.S. Navy is currently seeking new high-tech boats to increase its warfare capabilities at sea, including more carriers, destroyers as well as a next-generation ballistic nuclear submarine sometimes referred to as the Ohio Replacement Program. Each Ohio sub made by prime contractor General Dynamics is expected to cost upwards of $5 billion.

Despite General Dynamics shares' substantial appreciation since 2012, valuations are not as elevated as the other leading defense companies. General Dynamics forward P/E ratio is close to its 13-year median. We favor buying calls expiring February 17, 2017 with a strike of 155 currently trading for a premium of about 4.60, and corresponding puts with a strike of 140 currently trading for a premium of about 5.30. Unlike the previous three companies, we would be inclined to buy one put for each call, due to the fact that General Dynamics' valuations are not as elevated as valuations for Raytheon, Northrop and Lockheed Martin. Break-even is about 164.9 to the upside and 130.1 to the downside.

Conclusion

Leading defense companies General Dynamics, Raytheon, Northrop and Lockheed Martin have appreciated substantially since 2012. The current geopolitical terrain continues to be favorable for domestic and international defense orders and is unlikely to be affected negatively by upcoming U.S. presidential elections. Most likely, defense spending would increase in the intermediate terms under the next U.S. president irrespective of whether Hillary Clinton or Donald Trump is elected president. Meanwhile, valuations are quite expensive, currently at record levels from a P/E perspective, with the exception of General Dynamics. Investors can potentially benefit from a substantial move in either direction by establishing an options position, as provided above.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in LMT, RTN, NOC over the next 72 hours.

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.

Additional disclosure: I may initiate an options position over the next 72 hours, to buy calls and puts on LMT, RTN, GD, NOC, as provided in the article.