Recently I wrote an article targeting Raytheon (RTN) and noting that there may be some upside, especially if there is a pullback from its current stock price of $54. Raytheon had passed a screen I've developed looking for stocks with strong dividends and a low P/E, allowing for some value. However, three other major defense industry stocks also passed the cut: Lockheed Martin Company (LMT), General Dynamics (GD), and Northrop Grumman (NOC). I believe that there is some value in the defense industry, confirmed by major defense companies passing my screen. However, the industry also faces uncertainty with the coming fiscal cliff and the sequestration that may follow. Therefore, it is important to closely look at these four companies, and if you as an investor decide to develop some exposure to the sector, the stock that can best weather declining Department of Defense spending and an unstable economy should be chosen. Here are my screeners:
- Security Type: Common Stock - I am interested in investing in US-based companies.
- Market Capitalization: Greater than or equal to 740 Million - I am looking for middle-large cap companies who have established themselves in the marketplace.
- P/E (Intra-day/ TTM) - Less than or equal to 12 - I want a company with a lower than average P/E to give it some 'value' and room for the stock price to grow. Following the screen, I must compare this to the industry and historical average.
- Dividend Yield: Greater than or equal to 3.2% - I am looking for a yield above 3.2% to give myself a consistent stream of income above the current Treasury yield.
- Dividend Payout % Last Quarter: Less than or equal to 65% - while I would like a strong dividend, I want to ensure that the company is also investing some of its profits back into itself.
- Dividend Growth Rate (5 Year Average): Greater than or equal to 5% - I want a dividend that has, on average, been growing over the past five years. Following the screen, I must check the dividends declared to ensure consistency in the growth of the dividend.
Defense Industry Overview
The Aerospace & Defense industry is a sub-industry of the Industrials sector and accounts for the largest portion of the sector at 24.2% of the sector's value according to Standard & Poor's. Generally, operating leverage should show signs of improvement thanks to aggressive cost-cutting due to the 2008 recession. Most recently, troops have been fully withdrawn from Iraq and troops are gradually being removed from Afghanistan; on top of this, political pressure to decrease discretionary expenses (inclusive of defense spending) will lead to a smaller pie for all defense industry participants. S&P Capital IQ forecasts a decline in defense spending from slightly over $250 billion to about $150 billion by fiscal year 2023 representing a 48% decline in spending.
The upcoming fiscal cliff represents an even more immediate threat to defensive spending. Under sequestration, "the difference between the cap set in the Budget Resolution and the amount actually appropriated is 'sequestered' by the Treasury and not handed over to agencies to which it was originally appropriated by Congress". Lockheed Martin describes sequestration as a 'fog of uncertainty' and companies "have no insight as to… which programs will be curtailed; which sites will be closed, which technologies will be discontinued". If Congress does not get its house in order, sequestration could be devastating to the defense industry. I view it as highly unlikely that Congress will allow sequestration to occur, but the threat is always there.
While spending decreases, the 'pie' itself is also changing: new areas in defense have grown and become more essential. Specifically, drones and unmanned aircraft have become essential in fighting non-national enemies (read: terrorists and other groups) and national cyber security will continue to grow and be essential (evidenced by Chinese hackers attacking senior political e-mail accounts, other hackers attacking large US companies with international presences). The idea that cyber attacks and sabotage could constitute an act of war is becoming prevalent, although the idea is in its infancy and is very ambiguous. For example, President Obama is said to have utilized cyber warfare against Iran, raising the hypothetical question of 'is the US at war with Iran'?
Calendar of Events
Company | Q2 Earnings | Upcoming (or Most Recent) Ex-Dividend Date |
LMT | 7/23/12 | 5/30/12 |
RTN | 7/23/12 | 7/2/12 |
GD | 7/25/12 | 7/3/12 |
NOC | 7/25/12 | 5/23/12 |
Company Comparisons
Dividend Comparisons | |||
Company | Annualized Yield | Growth Rate (5-Year Average) | Payout Ratio |
LMT | 4.69% | 23.36% | 41.67% |
RTN | 3.66% | 14.42% | 30.88% |
GD | 3.23% | 11.95% | 27.17% |
NOC | 3.58% | 8.25% | 25.45% |
From a dividend perspective, Lockheed Martin shows the most promise as its annualized yield is a full percentage point higher than the second highest, Raytheon. It's also boasted a strong growth rate, albeit at a higher payout ratio than the other companies. However, a 41.67% payout ratio is not exorbitant. Raytheon's is also appealing given the much lower payout ratio, giving it room to defend not only its dividend but also the dividend's growth, while still maintaining a strong annualized yield.
Revenue Growth Comparisons | |||||
Company | FY 2011 Revenue Growth | FY 2011 EPS Growth | Q1 2012 Revenue Growth | Q1 2012 EPS Growth | Percent of Revenues derived from US Gov. |
LMT | 15.20% | 9.37% | 6.28% | 28.93% | 82% |
RTN | -2.52% | 9.71% | -1.88% | 24.30% | 74% |
GD | .65% | 17.42% | -2.81% | -4.82% | 69%1 |
NOC | -7.96% | 14.93% | -7.96% | 17.65% | >90% (inclusive of Foreign Military Sales, however) |
1GD also derives 10% of its revenues from US commercial customers for business-jet aircraft.
Margins Comparison | ||
Company | Gross Margin (Q1 2012) | Operating Margin (Q1 2012) |
LMT | 10.67% | 8.62% |
RTN | 23.43% | 12.04% |
GD | 20.44% | 11.35% |
NOC | 23.59% | 12.84% |
From the Revenue growth side, Lockheed Martin blows competitors out of the water. Despite the recent (and surely continuing) decline in fiscal spending this year, LMT still managed to post 15.20% revenue gains in 2011 and 6.28% revenue gains in Q1 2012. EPS Growth of 28.93% also puts LMT at the top. A note of concern is LMT's larger exposure to the US government than Raytheon or General Dynamic. General Dynamic's anemic revenue growth is disconcerting especially given its business-jet aircraft exposure, which, while giving the company a bit of diversity away from the US government and strict defense, is certainly tied to not-so-strong macro economic conditions. Meanwhile, NOC's extremely high exposure to the US government is more than enough to give an investor pause, despite the fact that it was able to increase EPS due to increased margins. From NOC's annual report, it is difficult to net out Foreign Military Sales, and I am cautious to make any assumptions.
On the subject of margins, Raytheon and Northrop are neck and neck at the top with General Dynamic a couple of percentage points behind. Here, Lockheed Martin lags significantly. Margin growth will be extremely important in the coming years given the decreased US government spending. If LMT is able to increase its relatively low margins while simultaneously grabbing larger portions of the revenue streams from the Department of Defense, it will be in much better position than its competitors. However, it is always difficult to eke out margins, and as such, RTN and NOC's positioning in terms of margins are much more comforting in a declining sales environment.
Valuation Ratios | |||||
Company | P/E | PEG | Price/ Cash Flow | Return on Investment (TTM) | Return on Equity |
LMT | 10 | 1.68 | 7.60 | 32.85% | 126.11% |
RTN | 9.7 | 1.12 | 7.78 | 14.29% | 20.93% |
GD | 9.1 | 1.22 | 7.2 | 14.1% | 18.29% |
NOC | 7.9 | 159.27 | 6.23 | 13.79% | 18.64% |
From the Valuation end, Raytheon has the lowest PEG which means it may have some room to gain in terms of stock price via this ratio. In a conflicting measurement, however, Raytheon has the highest Price/ Cash Flow indicating it may be slightly overbought compared to competitors (especially given the importance of bringing in cash for any firm). NOC's P/E is very low compared to its competitors, and this may be due to a pricing-in of its extremely high revenue percentage from the US government. RoI and RoE both point to LMT as being the strongest of the four candidates. Throughout all of the metrics, GD is typically average.
Backlogs
Company | Backlog (in billions) ending 2011 | Backlog Expected Conversion for 2012 (Percentage of Backlog) | Backlog Conversion as a Percentage of 2011 Sales |
LMT | $80.7 | $31.0 (38%) | 66.67% |
RTN | $35.3 | $17.8 (50.42%) | 63.90% |
GD | $57.41 | $33.02 (57.52%) | 101.05% |
NOC | $39.5 | $23.31 (59%) | 88.26% |
What can be gleaned from backlog projects is that GD, if it converts its expected backlog, will surpass 2011 sales from backlog alone. Meanwhile, LMT and RTN have much lower backlog conversion percentages of 2011 sales. LMT is expected to convert only 38% of its backlog in 2012, but given that it has the largest backlog by far, indicate that future revenues will remain strong.
Other Considerations and Information
Raytheon's been developing a strong exposure to cyber security, with the most recent acquisition in 2011 of Pikewerks. Its Intelligence and Information Systems business unit represented 12.13% of its net sales and 5.57% of its operating income in 2011. Its Space and Airborne systems has some unmanned drone capacity, although its leading revenues from that segment are derived from the Raytheon Applied Signal Technology (RAST) program.
Lockheed Martin's largest program is the F-35 Lightning II Joint Strike Fighter (an international multi-role, stealth fighter) under its Aeronautics' division, consisting of 42% of that division's revenue in 2011. Its IS&GS segment provides technology solutions and supports data protection and sharing in various industries. Cyber security does not appear to be a major focus of the segment, with modernization, integration, and automation programs dominating the segment. The other two segments, Electronic systems (surface ship and other combat systems) and Space Systems (satellites and missiles) round out LMT's product groups.
General Dynamics' Aerospace operations have been the company's growth engine, with revenues up 13% or $6 billion from 2010 to 2011; continued growth in the aerospace sector, which focuses on business-jet design, will be essential as the government ramps down defense spending, but growth is contingent upon economic positives. The Aerospace segment represented 19% of revenues in 2011. Meanwhile, the Combat Systems' international sales growth is also a positive, with export and foreign direct sales representing about 34% of growth volume. This will be important as the US ramps down budgeted spending. The company has exposure to cyber security, with its Information Systems and Technology unit representing 34% of revenues. 18% of this 34%, or 6.12% of total revenues, is derived from Intelligence, Surveillance, and Reconnaissance Systems, which offers cyber security. Interesting to note: GD focuses on its business units supporting themselves; each business unit has its own human resources, supply-chain management, and marketing and business development groups.
Northrop Grumman's Aerospace Systems focuses on unmanned aircraft, space systems, and other advanced technologies. Other segments include Electronic Systems (radar and the like), Information Systems (including cyber security), and Technical Services. Both unmanned systems along with cyber security are two growing and important fields to the US, and NOC expects about 75% of 2012 sales to come from unmanned systems, cyber security, logistics, and C4 Intelligence, Surveillance, and Reconnaissance (C4ISR). Given top line pressures, Northrop has consolidated business units and restructured debt and benefit plans.
Conclusion
Given that all of these companies have past my screen, I am hesitant to say that there is a 'bad' stock from this pick. I believe the Aerospace and Defense sector has some value despite future trends of declining revenue and the uncertainty of sequestration. However, if I were to rank the above companies, I would probably list them as such:
- RTN
While RTN falls behind LMT in some areas, it still has a strong dividend with a lower payout ratio than LMT. On top of this, its margins are very strong which is a huge positive in the face of declining government defense spending. RTN should also capture more of the defense 'pie' as it has strong exposure to cyber security, which I consider a necessity moving forward in the defense industry. Its RoI and even more so the RoE are strong, and its PEG indicates that RTN may be undervalued when compared to competitors. Furthermore, EPS growth is competitive even in light of declining revenues, which I believe in the long term LMT will eventually face as well. It also has a strong international presence.
- LMT
LMT has the strongest RoI and RoE illustrating its potential to generate returns on its capital and has been able to grow its EPS and revenues strongly especially compared to competitors. On top of this, it has the highest dividend yield and dividend growth rate, albeit at the cost of a slightly higher payout ratio. Negatives include that it has the highest P/E ratio and PEG ratio, indicating that some of the aforementioned strengths may be slightly more priced in than competitors. Finally, its margins lag significantly. Another note is that LMT does not appear to have much exposure to cyber or unmanned vehicles, and has more exposure to 'big-ticket' items than a company like RTN.
- GD
GD has the lowest annualized dividend yield but this is made up for by its higher dividend growth compared to NOC. Negative EPS growth in Q1 2012 is disappointing while a sub-1% FY 2011 revenue growth is not jaw-dropping by any means. However, it has the lowest exposure to the US government. Its slightly lower valuation ratios can be accounted for by its slightly lower RoI and RoE compared to LMT and RTN. A major factor with GD that is not applicable to any of the other competitors is its business-jet unit, which may prove to be a large asset if a strong economic recovery comes into play.
- NOC
The major thing holding Northrop Grumman back, in my opinion, is its >90% exposure to the US government. While it has increased its margin in the recent past, margins will be harder to increase while I see NOC experiencing the fastest revenue declines. Specifically, NOC improved margins in 2011 by moving its corporate headquarters and corporate downsizing, which is most likely more beneficial in the short term compared to the long term. Its margins are competitive with RTN's and place it at the highest of the group, though. However, its RoI and RoE are at the bottom of the bunch and helps to account for the lower valuation ratios. Perhaps the most positive thing to note is in its qualitative information: with exposure to both cyber security and unmanned systems, NOC puts itself at the forefront of two areas of large importance to the US government.
Overall, I think a case could be made for LMT or RTN at the top, while either GD or NOC could swap between 3rd and 4th place. This is not to say that GD or NOC are bad picks, as every company in the list has positives. With that stated, I believe that either LMT or RTN would make strong additions to a portfolio looking for exposure to the defense industry. Q2 earnings in July will definitely be helpful in gaining some further insights into how the rest of the year will play out for these companies.
One last point: it may be helpful to look at the charts of these companies to determine both good entry points and the general trend of the stock. It can also be helpful to see where a stock is in its price range. Furthermore, some investors find analyst opinions helpful while others claim to completely ignore them or even take the opposite view of an analyst. Regardless, always do your own due diligence!
Disclosure: I am long RTN.
