Raytheon, Lockheed Martin, Northrop Grumman All Undervalued

Includes: LMT, NOC, RTN
by: Colin Lokey

Defense stocks are out of favor lately. Raytheon (NYSE:RTN) Northrop Grumman (NYSE:NOC) and Lockheed Martin (NYSE:LMT) are all trading near their respective 52-week lows. Raytheon is trading near a two-year low. Investors are concerned that the winding down of operations in Iraq and Afghanistan combined with $400 billion in military spending cuts over the next 12 years will severely impair defense companies' earnings.

Despite any drag on revenue occasioned by the U.S. withdrawal from Iraq and Afghanistan, defense companies will still benefit from spending associated with the war on terror. Additionally, the increasingly tense and contentious political environment worldwide will likely cause governments to refrain from making precipitous cuts to their defense budgets.

Raytheon, Northrop Grumman and Lockheed Martin are all undervalued based on their forward price-to-earnings ratios; they go for 8.2, 7.5 and 9.4 times projected 2011 EPS, respectively. Also, the companies consistently beat earnings expectations: Northrop has beaten analysts' estimates in six straight quarters and Raytheon and Lockheed have surprised to the upside in four of their last six quarterly reports. All three pay a good dividend as well. Raytheon yields 4.17%, Lockheed pays out 4.2% and the number for Northrop Grumman is around 3.9%. The companies all report third quarter earnings towards the end of October.

If you are trying to decide among the three, here are a few things to consider. Lockheed Martin's ROE number is more than triple that of Raytheon and Northrop Grumman at 67.5%. This means Lockheed is able to generate much more profit with shareholders' money than its competitors. However, Raytheon and Northrop Grumman both have a significantly lower percentage of long-term debt to capital than Lockheed. Of the three, Raytheon had by far the lowest percentage of its shares sold short as of August 29.

Defense stocks have fallen too far lately. All three of the companies mentioned above are undervalued by many metrics and all three pay a handsome dividend. Consider adding them to your portfolio while they still trade near their 52-week lows.

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