3 Defense Stocks With Strong Upside Potential

 |  Includes: BA, LMT, RTN
by: Vatalyst

Since the attack on the World Trade Center in 2001, the defense budgets of many countries have been on the rise. Many leading economies have recently increased spending on combat and defense preparation. This trend is likely to continue due to the ongoing political turmoil across the globe.

Hence, the aerospace and defense industries will likely multiply exponentially in the coming years, providing many lucrative investment opportunities. Within these sectors, Lockheed Martin (LMT) offers a good starting point for analysis, due to its technical superiority and range of products that it offers customers, especially the US government.

Lockheed Martin is the largest defense contractor for the US government, spending about $925 billion annually. It has a presence in four distinct segments: aeronautics, electronic systems, information systems, and space systems. To further its presence in the core government sector, Lockheed Martin acquired QTC Holdings (QTC) in 2011; QTC was the largest provider of medical evaluation services to the US government departments at the time.

Lockheed Martin also sold off Pacific Architects and Engineers (PAE), a provider of logistics support services to the US government and various other governmental organizations around the world. These actions display the company's sound strategic vision.

Furthermore, the US is gradually reducing its overseas presence and is diverting its resources toward internal causes, which could mean more business for medical service providers. Hence, Lockheed Martin has wisely diversified to offset the move by the US to cut its defense budget, thereby insulating itself to a great extent from the global recession.

The market capitalization of the company stands at $28 billion, with last year's sales reaching nearly $46.5 billion. It also has an extremely high ROE of 118.59%, and ROI of 10.78%, against an industry average of 21.3% and 4.9%, respectively. Though the company trades near its 52-week high, it has an extremely low P/E of 11.41, against an industry average of 20.8 and 26.33, respectively.

Lockheed Martin has a healthy EPS of about $7.82, making it a cheap stock in terms of its current valuation. The stock also displays a high level of stability with a low beta of 0.91. In the past, the company has surprised most analysts with its higher earnings, resulting in higher forecasts by analysts for forthcoming years.

Another major player in the aerospace sector is Boeing (BA). Like Lockheed Martin, it has a very large market capitalization at $55.4 billion. The company boasts earnings of almost $69 billion, with an annual growth of almost 18%. However, the company has a slightly lower operating margin of 8.06%, compared to 8.14% for Lockheed Martin.

Boeing's EPS is also significantly lower at $5.34 when compared to Lockheed Martin. This is further reflected by a higher P/E of 13.92 compared to that of Lockheed Martin. The company does have a major share in the global aviation industry, with its 787 Dreamliners being received well. However, with the global recession, both the defense and aviation sectors are undergoing cuts, and this is impacting the future earnings of Boeing. This is evidenced by the company's recent decision to close down a facility in Wichita by 2014.

Another industry player is Raytheon (RTN). Like Lockheed Martin, this company is experiencing steady earnings growth. It has a lower P/E than Lockheed Martin at 10.16, and also a lower EPS of $5.19. The market capitalization is also smaller at about $17.92 billion, with revenue of about $24.9 billion (against $46.5 billion for Lockheed Martin).

Raytheon is currently operating at a higher margin than Lockheed Martin at 11.74% and has an extremely low beta of 0.73, making it a highly stable and reliable stock. The company has also recently been awarded contracts from the US Navy to provide engineering, technical and depot services to 15 Air Traffic systems, making it another lucrative company for investments. However, the company does faces a risk to its future earnings prospect due to the proposed defense budget cuts of the US Defense Department - its primary customer.

Lockheed Martin has achieved the unique distinction of being the prime contractor for strategic system programs used by the US Armed Forces. It has also succeeded in winning a seven year contract of $841 million from USAF for Sniper Advanced Targeting Pod (ATPs). Added to its list of achievements is the production of a prototype radar system for outer space objects, which will generate immediate revenue of $107 million, with prospects of further orders from the US and other governments in the years to come. Hence, Lockheed Martin has displayed an unmatched reliability record in the defense system, which insures the company's profitability in both the short and long term.

There is some risk to Lockheed Martin's future earnings in the form of its project on F-35 fighter aircraft. Though it has been awarded multi-billion dollar contracts from the US and its allies, there are delays and cost issues in its test and manufacturing program. Speculations have arisen that the pending orders may be cancelled. Investors looking at Lockheed Martin should keep a close watch on this project.

Keeping the above factors in mind, Lockheed Martin is indeed a stock worthy of investment. The company has been showing stable growth, even through the recession, with sufficient orders from both the military as well as the commercial sectors. Lockheed Martin receives about 82% of its revenue from the US government and has an order backlog of approximately $80.7 billion. Further, its sales have the potential to grow even more, given the US government's willingness to transfer technology and military equipment to its ever-expanding allies. I strongly recommend buying shares of Lockheed Martin in today's scenario.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.