Davy Bui's  Instablog

Despite the partisan hand-wringing over a Democrat in the White House, yesterday's release of the defense budget served notice that U.S. defense spending isn't being pared back, not with two wars and a ramp-up planned in Afghanistan. Additionally, recent articles suggest possible trends in future defense spending:

• Electricity Grid in U.S. Penetrated By Spies [WSJ]
• Defense Firms Pursue Cyber-Security Work [WSJ]

From the looks of it, the defense industry isn't going anywhere anytime soon. However, the defense stocks haven't escaped the market crash and look cheap despite the recent broad rally. I examined some of the big-name defense companies and a smaller defense information systems play, looking at returns on capital/equity, debt levels, backlogs and free cash flows:

View the defense stocks spreadsheet

These valuations are very rough, with no adjustments made for future prospects, backlog, company-specific headwinds, etc. Nevertheless, a rough DCF on the stocks show all six stocks selling at a discount to intrinsic value as suggested by averaging various scenarios based on the last six years. Furthermore, every stock had a PEG ratio under 1 and the defense industry has better earnings visibility due to government patronage and robust backlogs.

My quick survey reveals Boeing (BA) and CACI International (CAI) as the most undervalued with 38-39% margins of safety, based on rough FCF valuations. Coincidentally or not, these two stocks also have the highest leverage ratios in the list.

Based on operating metrics, Lockheed Martin (LMT) and General Dynamics (GD) seem the clear winners with highest returns on invested capital and equity. They also yield over 3% with payout ratios of 31% and 22%, respectively, so future dividends look secure.

Northrop Grumman (NOC) and Raytheon (RTN) sport the lowest PEG ratios but that may be a reflection of poor standing among investors, leading to a lower P/E ratio relative to expected growth. Over the last six years, these two companies put up the lowest ROIC and ROE numbers.

Keep in mind  these numbers are backward-looking and give little indication into future prospects. However, the defense industry as a whole looks promising relative to other industries and it may be best to forego the attempt to pick winners. To that end, a defense/aerospace ETF like the iShares Dow Jones US Aerospace & Defense ETF (ITA) or PowerShares Aerospace & Defense Portfolio (PPA) may be the best bet. According to ETFConnect, PPA's distribution is more than double ITA's yield so discerning investors may want to dig into the specific holdings.

View the defense stocks spreadsheet

Disclosure: No positions