Ukrainian/Russian Conflict And Impact On Defense Stocks: Boeing And Lockheed Martin

Summary

• If you want peace, prepare for war. All major countries (China, U.S., Germany, et al) are prioritizing their military spending.
• These developments signal a new cycle for the defense sector, and you will see the specific implications for 5 major defense stocks in this article.
• Boeing Company seems to be misunderstood by the market as a civilian airplane manufacturer, even though almost 40% of sales now derive from defense contracts.
• Lockheed Martin may finally breakout of its multi-year price range and valuation compression.
• Atypical stock like Booz AllenHamilton can also help you tap into the cycle with tailored risk/rewardprofiles.
• I do much more than just articles at Envision Early Retirement: Members get access to model portfolios, regular updates, a chat room, and more. Learn More »

gece33/iStock via Getty Images

Thesis Overview

If you want peace, prepare for war. The Ukrainian/Russian conflict just heightened the world’s awareness of wisdom from the Roman general Vegetius. The following chart shows the global defense budget in the past and projections up to 2030. As you can see, the global defense budget has already been increasing faster than GDP and faster than inflation for many years is projected to further accelerate in the next 10 years.

Source: Global defense budget.

And here is the punchline: this chart was made BEFORE the Ukrainian/Russian conflict broke out. All major countries (China, the U.S., et al) have already been prioritizing military spending before the conflict. And the conflict only heightened global awareness of the need to prepare and defend peace. A few notable new examples since the conflict broke out:

• BERLIN, Feb 27 (Reuters) - Chancellor Olaf Scholz said on Sunday Germany would sharply increase its spending on defense to more than 2% of its economic output in one of a series of policy shifts prompted by Russia's invasion of Ukraine. Scholz said the government had decided to supply 100 billion euros for military investments from its 2022 budget. Germany's entire defence budget by comparison was 47 billion euros in 2021.
• BEIJING, March 5 (Reuters) - China will spend 7.1% more on defense this year, outpacing last year's hike and the government's modest economic growth forecast as Premier Li Keqiang seeks to safeguard the country's sovereignty, security and development interests. Li pledged to enhance military training and combat readiness for the People's Liberation Army, which is developing an array of weapons from stealth fighters to aircraft carriers.
• WARSAW, March 3 (Reuters) - Poland will raise spending on its armed forces more than planned, the government said on Thursday, as a Russian invasion of neighbouring Ukraine focuses attention on Warsaw's defence capabilities.

Under this background, this article will analyze 5 defense stocks. To us, these above developments signal a new cycle for the defense sector. You will see the specific implications for 5 major defense stocks in this article, so you can make an informed decision tailored to your risk profiles and needs. And this brings us to the thesis of this article:

• Boeing Company (NYSE:BA) seems to be misunderstood by the market as a pure civilian airplane manufacturer, even though about 40% of its revenues are already derived from defense contracts. And this portion is expected to further increase. Given its current valuation and business fundamentals, we see BA as high risk and high return opportunity in the defense sector.
• Lockheed Martin (NYSE:LMT) represents a good case study for value investing, which is all about getting the market to agree with you – LATER. And it may now finally break out of its multi-year price range and valuation compression. And LMT represents a typical defense stock best poised to benefit from the new global defense cycle. It enjoys wide moat, technological superiority, and long-term government commitment. On top of all these, the new developments just added additional catalysts. For example, with its increased defense budget, Germany could purchase U.S. F-35 fighter jets built by LMT to replace its aging Tornado.
• The positives of LMT are also applicable to other major defense contractors. And we will analyze two of them briefly following LMT - Raytheon Technologies Corporation (RTX) and General Dynamics (GD).
• Lastly, we will analyze an atypical stock, Booz Allen Hamilton (BAH), under the context as a defense stock. It can also help you tap into the cycle with tailored risk/reward profiles because of its unique role as a consulting firm with the U.S. government and the defense department as its main customers.

BA - misunderstood by the market

As you can see from the following chart, its stock price (the blue line) has been under pressure and has lost almost 16% YTD. In contrast, other defense stocks (such as LMT plotted here) have rallied substantially during the same period. What is even more telling is what has transpired in the recent few weeks since the Russian invasion broke out on February the 24th. As you can see, LMT (and other defense stocks) have gone up significantly since then. But BA’s price kept declining.

The market seems to keep viewing BA as a civilian airplane manufacturer, not a defense contractor. Even though the reality is that almost 40% of sales now already derive from defense contracts, the role of defense and space operations will only increase with the recent developments as we will see next.

Yahoo Finance

Since we are focusing on BA’s defense segments, I will only make a few very brief comments about its civilian segments. The civilian segment was caught up in a perfect storm in recent years. The COVID pandemic halted airplane travel. And at the same time, its flagship 737 MAX had been grounded for nearly two years following a crash in Indonesia that killed 189 people. These major events dragged the business into the red, and most likely will keep it in the red for the third year in a row.

However, we are not too concerned about its long-term prospects. Ultimately, BA is too important for the national interest. At the same time, we see several green shoots on the near horizon for its civilian segments (e.g., the successful return of its 737 MAX, the recovery of travel, et al). And finally, the stable and recurring defense revenue and strong government support will ensure its long-term profitability, which brings us back to its defense segments.

Almost 40% of its sales now already derive from defense contracts. The role of defense and space operations will only increase with the recent increases in the global defense budgets as aforementioned. The defense and space operations ought to boost its cash flow contributions. And specifically,

• Its Defense, Space & Security keeps capturing new and follow-on businesses successfully. A $23.8 billion contract awarded to Boeing in September for military transport aircraft is the latest win. It has also won an award for modernization of AWACS for the Royal Saudi Air Force, and multiple contracts for proprietary space programs. All told, the orders from the Defense, Space & Security segment now are valued at $7B in 4Q21 and $25B in 2021. And the total backlog stands at $60B.
• In addition, its Global Services ought to boost their cash flow contributions too. Its outlook for government services remains stable even before the Russian/Ukraine conflict broke out. It has been awarded contracts for F/A-18 landing gear repair from U.S. Navy, and selected to provide Apache training and support by the U.K. All told, the orders from its Global Services segment are valued at $6B in 4Q21 and $16B in 2021. And the total backlog stands at $20B.
• So if you completely ignore the civilian segment and only combine its Defense, Space & Security and Global Services segments, the total orders in 2021 are about $41B already, and the backlog about $80B. To put things into perspective, its 2021 total revenue is about $62 billion. And the total backlog, just from these two segments, is already more than its 2021 total revenues.

As a footnote before leaving this topic, note that these two segments accounted for about 2/3 of the total revenue in 2021. And earlier I quoted 40% of total revenue coming from defense contracts. This is because not all the sales from the Global Services segments are defense contracts.

Boeing investor presentation

Now onto valuation. Firstly, the market mood has been so negative that the valuation has become very attractive. The stock has been historically trading around 2.2x times its sales. Right now, it is trading at only about 1.64x of its 2021 sales and 1.24x of its FW sales (according to the data from Seeking Alpha as of this writing, Mar 9 about 10am). I’m being precise to the hour here because of the current extreme market volatility. These numbers can change substantially from day to day. And the overall market (represented by the S&P 500 index) is trading at about 3x price to sales ratio. So BA is now trading at a substantial discount not only relative to the overall market (by about ½) but also from its historical average.

At the same time, there are also huge upside potentials because of the business fundamentals mentioned above, both on its civilian side and also more reliably from its defense side. The successful return of its 737 MAX will be a top catalyst on the civilian side, especially if China, a key customer, approves the certification of the 737 MAX. On the defense side, BA will keep enjoying strong government support and also the global secular trend. It is a business too important for national interest and security as aforementioned.

With the valuation compression and potential catalysts, the price in the next year or so could see a large upside swing. As shown below, even if valuation remains at the current 2x sales level, the price can reach $290 with next year’s projected sales. And if valuation reverts to its historical average of 2.2x sales, the price could reach $315.

Yahoo Finance

LMT – a good case study for value investing

I have been a long-time bull on LMT and published my first bull thesis back in May 2021 on Seeking Alpha. The thesis at that time was it is “A Great Business At A Fair Price”, and the thesis is based on the following reasons to be detailed next. And now I see these reasons are still valid today (probably even more so with the breakout of the Russian/Ukraine conflict).

Seeking Alpha

Wide and durable moat

The business is protected by a wide and durable moat, created both by sheer technological superiority, scale, and customer relationship. Due to my job experiences, I happen to know quite a bit of the technical aspects of their F35 business. Innovations like supersonic flight both with and without afterburning, the long-range ability, and the short take-off and vertical-landing (STOVL), are so ahead and only these features alone would take competitors decades to catch up. And the aerodynamic aspects are only the tip of the iceberg of its technological lead. The business boasts other dramatic leads in electronics, sensor fusion technology, radar, stealth technology, et al. These technological leads are sufficient to make the business essentially a monopoly with no alternative in sight.

Unique customer trust and product cycle

Customers (the biggest one is the United States) are sticky and switching cost is prohibitive. In Warren Buffett’s words, this is a business with a wide moat that is filled with crocodiles.

Apple has to release a new iPhone every year or so. But the product cycles for many of LMT’s products are in decades. Take its F35 program again. The U.S. plans to acquire about 3,000 of these planes in its arsenal (at an average acquis ion price tag of $80M so far). LMT started the development of the program back in 1995. To date, LMT has “only” delivered 600 of them thus far in total, and the remainder of them will be delivered in the next 10~20 years and will remain in service for many decades to come. Such a unique product cycle and government commitment really provide long-term stability to the business, putting short-term issues like the switch of a president into perspective.

R&D yield rivals Apple

A crucial metric to gauge the moat and staying power of tech-oriented businesses is its R&D efforts and R&D yields. The next chart shows LMT’s R&D yield, defined as how many dollars of operating income has been generated per every $1 of R&D investment. As you can see, the R&D yield for LMT has been very consistent and averaging $4.8 in recent years. This level of R&D yield is very competitive even when compared to AAPL (about $4.7). And MSFT’s R&D yield has “only” been averaging about $2.9.

The secret weapon that LMT enjoys here but AAPL and MSFT do not is the long-term government support and customer commitment. The nature of the defense industry really removes much of the uncertainties in plant, equipment, and R&D investments for leaders like LMT. A large part of the R&D is sponsored by the U.S. government. So that LMT does not only already have great certainty on the return of R&D efforts before they make such investment decisions, they have such certainty for many years or even decades to come.

Source: Author based on Seeking Alpha data.

Yet it lost almost half of its stock price as you can see from the following chart. The reason for such a large price drop was due to the uncertainties in the U.S. government military budgeting (we just switched president) and also the COVID interruptions. The price volatility brought the valuation to only 14.5x PE at that time. Too cheap in our view given the quality of the business.

We then researched and waited – for more than a year (as shown in the yellow window in the chart). We are long-term investors and therefore we get to be opportunistic. And finally, we started accumulating shares in the second half of 2021 (the blue window shown in the chart). We feel very confident to act at that time for two reasons:

• Fundamentals, we feel we understand its business by that time much better (our background in R&D and consulting experiences in the aerodynamics industry helped). We saw the budgetary and COVID issues as only temporary, and do not impact the moat or secular trend of the business.
• The market clearly does not know what to make out of the stock as shown by the range-bound price actions. The price kept going back and forth in a narrow range between about $325 to $400 for almost two years. And we saw no deterioration of the business fundamentals at all during this period of time.

Looking forward, we see the valuation still reasonable (about 16.7x FW PE) and the recent developments add further catalysts. For example, as aforementioned, Germany has decided to supply 100 billion euros for military investments from its 2022 budget, and part of it could be used to purchase U.S. F-35 fighter jets built by LMT to replace its aging Tornado.

And finally, I will close by repeating what I wrote to our market service members on Feb 27, 2022. I still hold these same following views now.

• In case you are also holding LMT shares, we strongly suggest you DO NOT sell and take your profit now. This is the time that we have been anticipating ourselves for almost 3 years. And we are going to the profit its chance to run.
• On the other hand, if the price ends up keeping trapped within the range, it is ok. Let it be range-bound for as long as it wants – as long as there is no deterioration in the business fundamentals. We’ve seen this movie many times before.
• Although, if the price begins to drop significantly below $300, we will have to re-examine the business fundamentals and our thesis in that case.

Author and Yahoo Finance

RTX and GD – similar thesis as LMT

The positives of LMT are also applicable to other major defense contractors. And we will analyze two of them briefly following LMT - Raytheon Technologies Corporation (RTX) and General Dynamics (GD).

RTX is another major aerospace and defense contractor that makes and services commercial and military aircraft engines. It also develops missile defense systems for 17 nations around the globe. The cornerstone of its defense segment is the Patriot air and missile defense system, a highly adaptable mid-range solution. The company was awarded several sizable projects in the fourth quarter. Some of the most lucrative contracts in the group include deals with the United States Navy and international customers for Standard Missiles valued at $729 million. Its recent merger with United Technologies in 2020 further strengthens its leading position in the defense industry. The company enjoys the highest level of financial strength (A+) and superb earnings consistency.

In terms of valuation, as you can see, it is fairly valued despite the recent price rallies. For the next 3~5 years, an upper-single-digit annual growth rate is expected (about 7.5%). And the total return in the next 3~5 years is projected to be in a range of 32% (the low-end projection) to about 43% (the high-end projection), translating into a healthy 7.3% to 9.4% annual total return, a very solid return when adjusted for risks considering its super financial strength, earning consistency, and also the increase of global defense spending expected ahead.

Author

Like LMT and RTX, GD is another major defense stock protected by a wide and durable moat, created both by sheer technological superiority, scale, and customer relationship. Due to my day job, I happen to know quite a bit of the technical aspects of the hydrodynamics of their marine systems. Innovations in these aspects are so ahead and would take competitors decades to catch up. And the hydrodynamics aspects are only the tip of the iceberg of their technological lead. Take GD’s Virginia class nuclear-powered submarine. It is the U.S. Navy's latest undersea warfare platform which incorporates the latest in propulsion, stealth, intelligence gathering, and weapons systems technology. These technological leads are sufficient to make a good chunk of their business essentially a monopoly with no alternative in sight.

In terms of valuation, its current valuation (15.6x operation cash flow) is very reasonable or even compressed for wide moat business leaders. Although in relative terms, it is a bit above its historical average after the recent price rallies. For the next 3~5 years, an upper single-digit annual growth rate is expected (about 8.5%). And the total return in the next 3~5 years is projected to be in a range of 21% (the low-end projection) to about 38% (the high-end projection), translating into a healthy 4.9% to 8.3% annual total return. Like the case of RTX, it is also a very solid return when adjusted for risks considering A+ financial strength, A+ earning consistency, and also the increase of global defense spending expected ahead.

Source: Author

BAH – an atypical defense play

Lastly, let’s look at an atypical defense stock, Booz Allen Hamilton (BAH). It is atypical in the sense that it does not directly manufacture weapon systems. It is a consulting firm with the U.S. government and the defense department as its main customers. As such, it can also help you tap into the cycle with tailored risk/reward profiles because of its unique role. A few highlights:

• Even though it does not directly manufacture weapon systems, it shares many traits with the other defense contractor analyzed above. It enjoys government support and commitment in the long term. It has had contracts with the U.S. Army and Navy for more than 70 years.
• Then unlike the other defense contractors, it has a more diversified revenue source. It provides management and technology consulting services to both the defense and civil branches of the U.S. governments, and also other major corporations, and institutions. Although, the majority (more than 97% in 2020) of revenues were derived from contracts where the end client was an agency or department of the U.S. government. The Navy-Marine Corps accounts for 13% of the top line.
• Because of its more diversified revenue sources, it has actually demonstrated almost comparable price stability and earnings stability compared to the other major players – even though its market cap is less than 1/10 of them. Its market cap is about $10B, while the others (BA, LMT, RTX) are all above $100B.

Source: Portfolio Visualizer

Lastly, valuation. Its current valuation (15.7x operation cash flow) is very reasonable both in absolute terms and also relative terms (relative to the other defense stocks or to the overall market). In terms of dividend yields, its current yield is substantially higher than its historical average and indicates a substantial margin of safety. For the next 3~5 years, an upper single-digit annual growth rate is expected (about 8.5%). And the total return in the next 3~5 years are projected to be in a range of 42% (the low-end projection) to about 69% (the high-end projection), translating into a healthy 9% to 14% annual total return.

Author

Summary and final thoughts

Under this backdrop of heightened global defense spending, this article analyzes 5 defense stocks. To us, they are all well poised for the new cycle of defense spending. Specifically,

• BA seems to be misunderstood by the market as civilian airplane manufacturer, even though more than 40% of its revenues already derive from defense contracts. And this portion is expected to further increase. Because of such misunderstanding and mispricing, we see BA as high risk and high return opportunity in the defense sector.
• LMT represents a good case study for value investing, which is all about getting the market to agree with you – LATER. It may now finally break out of its multi-year price range and valuation compression.
• The positives of LMT are also applicable to other major defense contractors such as RTX and GD. These high-quality stocks are still very reasonably valued despite the recent price rallies. Their potential returns are very appealing when adjusted for risks considering their A+ financial strength, A+ earning consistency, and also the increase of global defense spending expected ahead.
• Lastly, atypical defense stocks like BAH could help you tap into the cycle with tailored risk/reward profiles because of their unique role in the ecosystem.

Finally, a word about the risks. I won’t be able to dive into the risks of each individual stock here (that would probably double the length of this already-long article). I will limit myself to the risks common to all my analyses above:

• All the above analyses are more oriented toward the long term. All the fundamental positives, even the heightened global defense spending, are long-term effects. And the short-term price behaviors do not necessarily flow the long-term trend all the time.
• In the near term, many factors could create substantial price volatility. For example, the Ukraine/Russian conflict is a big near-term uncertainty. The duration and eventual outcomes of the conflict (as with any geopolitical conflict) are totally uncertain. It could generate substantial impacts for both the global overall financial markets and the defense stocks in unpredictable ways. Furthermore, the pace and degree of the post-COVID economy recovery are also uncertain. Although the vaccination is progressing extensively and the economy is re-opening at a steady pace. However, the pandemic is far from over yet and uncertainties like the delta and omicron variants still exist. These uncertainties could impact the demand-supply dynamics.

Disclosure: I/we have a beneficial long position in the shares of LMT, GD either through stock ownership, options, or other derivatives. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.