With the conflict with Iran heating up and the continuing threat of terrorism from numerous regions, the countries of the world have a need to maintain sophisticated defense systems. The United States and its allies rely on defense companies to build this infrastructure. The defense and aerospace companies are all relatively stable, but some are better investments than others. We'll take a look at these companies side by side to determine the best investment among the group.
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Interestingly, according to Deloitte Touche Tohmatsu Limited (DTTL), the aerospace and defense companies are expected to benefit more from a new growth cycle in production of commercial aircraft over defense related aircraft. DTTL sees increasing demand for leisure and business travel particularly in the Asia Pacific region. The global defense market is experiencing a decline due to decreased spending by the United States and Europe. On the other hand, defense programs are growing in emerging markets such as India, Brazil, Saudi Arabia, United Arab Emirates, Japan, and South Korea.
Northrop Grumman has a nice dividend, but it is expected to suffer a loss in earnings growth of (11.10%) for the year and its five year annual earnings growth is negative. I do like its valuation and balance sheet, but I would pass on this one as there are others that should perform much better.
Northrop derives 90% of its revenue from the U.S. government. It has received over $469 million in contracts this year for: NATO's cyber security requirement; CANES shipboard network for the US Navy; LITENING SE targeting pods for the US Air Force; Army National Guard training support; repairs for US Navy's SH-60 and EA-6B aircraft; solar electric propulsion flight concepts for NASA; Airborne communication nodes on Global Hawks; US Army's C-RAM contract; micro scale power conversion contract; US Air Force design and engineering support; and for Marine navigation equipment for Suez Canal Authority.
Lockheed Martin has the highest dividend of these companies at 4.5%. Although it is fairly valued, I think that it will continue to perform slightly better than the market when you look at its total yield (dividend plus earnings growth). This total yield should provide investors with an average annual gain of 12.7%. Lockheed has 3 upward earnings revisions for 2012 and two upward revisions for 2013. It exceeded earnings estimates in its last four quarters.
Lockheed has the most clout with the U.S. government and is the highest recipient of government contracts (approximately $36 billion per year). Lowered defense spending does pose a risk to its revenue and earnings, but this is factored into its current estimates.
It derives 80% of its revenue from defense contracts. Lockheed has received over $2.1 billion in contracts thus far in 2012 for: JIEDDO OPS services contract; US Army research lab support; combat- proven PAC-3 missiles; and for the US Air Force's GPS III satellites and C-130 training devices.
Another solid company in this space is Raytheon. It is currently undervalued as the stock trades at only 2.11 times book value per share. Raytheon pays a nice dividend of 3.4% and has similar expected earnings growth to that of Lockheed. Its total annual yield of 11.56% should also edge higher than the market. The company has one downward earnings revision for 2012 and one upward revision for 2013. RTN exceeded earnings estimates in three out of four quarters last year.
Raytheon is responsible for producing the well-known Tomahawk cruise missiles that are supplied to the U.S. Navy. It also offers an extensive array of sophisticated defense products and services for military applications.
About 90% of Raytheon's revenue comes from defense contracts. It has received over $710 million in contracts so far in 2012. These contracts are for: Friendly forces communication during electronic warfare; US Navy contract for AIM-9X; Missile Defense Agency systems; Naval power station contract; translation capabilities for the US Army; Patriot missile upgrades; US Air Force field service support; US Navy's LPD 26; US Navy's Airborne Low Frequency Sonar; Seasparrow Missile; and for a new missile defense interceptor.
General Dynamics is another undervalued, dividend paying (2.6%) defense contractor. It obtains 80% of its revenue from defense spending. The dividend is lower than that of LMT and RTN and its expected earnings are also slightly lower. However, GD did exceed earnings estimates in all four quarters last year. It also has an upward earnings revision for 2012 and an upward revision for 2013.
General Dynamics has received new contracts totaling over $950 million so far in 2012. These contracts are for the following projects: DDG 51 Class Destroyer; US Navy submarine work; Naval Medical Logistics Command research; F-35 Lightening II Gun systems contract; standard missile-3 control actuators; U.S. Army Gatling guns; Task order from US Department of the Interior; Navy Medicine research support services; Composite winglets for Spirit Aerosystems; Abrams Tank upgrades; and Trident II submarine strategic weapons systems.
Esterline is a $2.1 billion mid-cap aerospace and defense manufacturer. It has a few good things going for it. First, the company is the most undervalued among the group as the stock trades at only 1.26 times book value per share. It is also growing consistently faster than the other companies. In the last five years, Esterline has grown earnings annually at 15.43%. It is also expected to grow earnings annually at 15% for the next five years.
Since stock prices rise in relation to earnings growth over time, Esterline should double its stock price in the next five years. It achieved a 75% gain over the last five years, which underperformed its earnings. So, due to its current undervaluation and future earnings expectations, Esterline has the potential to double in the next five years.
In addition to defense and aerospace, Esterline also operates in the industrial, medical, energy and gaming fields. It derives 80% of its business from defense and aerospace and 20% from the others.
Esterline doesn't pay a dividend as its reinvests its earnings to grow the company. This should be acceptable to investors since the company can grow earnings at 15% per year, which will outperform most of the dividend paying defense companies. As a mid-cap company looking to expand, the reinvestment of funds to grow the company makes sense.
Textron is a $7.56 billion mid-cap company that operates in the aircraft, defense, industrial, and finance businesses. Its stock is attractively priced as it trades at only 1.96 times book value per share. It has beaten earnings estimates in three out of four quarters in 2011. TXT has one upward earnings revision for 2012 and two upward revisions for 2013. Annual earnings growth for the next five years is expected to be an aggressive 36.05%.
Some of Textron's brands include Bell helicopters, Cessna airplanes, E-Z-GO, Greenlee, Jacobson, and Kautex. More than one third of general aviation aircraft carries the Cessna name. Textron also produces armored security vehicles, unmanned aircraft, precision weapons, situational software, windshield and headlamp washer systems, engine camshafts, plastic containers, powered equipment, fiber optics assemblies, golf course turf maintenance equipment, off-road vehicles, and more.
Textron is different from the other companies listed in this article as it derives only 31% of its revenues from U.S. Government contracts. This gives it an edge over the others as it will benefit more from the rise in demand for commercial aircraft and it will experience less of an impact from reduced defense spending.
Growth in the commercial aircraft industry is expected as a result of addressing increasing fuel costs. Next-generation engine technology will be needed for more fuel efficient aircraft. Increasing demand for business and leisure travel in Asia is also contributing to higher aircraft demand. For these reasons, Esterline and Textron look like the winners as they have more exposure to the commercial aircraft industry, hence their higher expected earnings growth.
Esterline's products are included on the Boeing 787, Boeing 737 Max, Airbus a320neo, and Airbus a350. Textron manufactures light and mid-sized business jets, utility turboprops, and single engine aircraft.
Lockheed and Raytheon will also prove to be good market beating investments when taking the combination of dividends and stock appreciation into account. However, I think that Esterline and Textron will outperform them in earnings growth and overall stock appreciation in the next five years.