As U.S. defense officials start getting used to the idea of dramatic cuts to military spending, major contractors like Boeing (NYSE:BA) and Lockheed Martin (NYSE:LMT) are bracing for mandatory reductions of $600 billion in defense and national security budgets. Contractors saw the writing on the wall when the congressional supercommittee fumbled the deficit-reduction ball last Thanksgiving, triggering $1.2 trillion in automatic spending cuts beginning in 2013 in both defense and nondefense programs.
Faced with what Defense Secretary Leon Panetta termed a “doomsday scenario,” he plans to scrap DOD’s long-standing strategy of being able to fight two wars simultaneously. The havoc such a move would wreak on contractors’ revenues adds an exclamation point to the defense sector’s fears.
When you’re looking to cut that much money from the budget, you must hit some big and very lucrative projects — and Lockheed Martin is on the frontlines of a couple of the most at-risk programs. The top-line item on DOD’s cutting block is likely to be LMT’s delayed and cost-overrun-plagued F-35 Joint Strike Fighter.
With a price tag fast approaching $400 billion for the first 56 of the stealthy jets, it’s easily the priciest procurement program underway now. Sentiment also is cooling for the U.S. Navy’s Littoral Combat Ship, which LMT and General Dynamics (NYSE:GD) separately produce at about a half-billion dollars a pop.
Boeing could lose the V-22 Osprey tilt-rotor aircraft, which is produced in partnership with Textron (NYSE:TXT) subsidiary Bell Helicopter. Although the U.S. Marine Corps loves the V-22, which looks like a helicopter and flies like a propeller plane, the Pentagon could save as much as $8 billion if it cancels the next 122 aircraft.
Conventional wisdom would suggest that with cuts of this magnitude, shares of these and other major defense contractors are certain to circle the drain in 2012. And make no mistake: They will slump this year. But penning an epitaph for BA and LMT right now is premature, and investors who succumb to fear risk leaving money on the table.
Although Boeing and Lockheed Martin are heavily dependent on Uncle Sam’s weapon systems business, both companies are holding pocket aces in international and nondefense markets. Just take a look at the recent orders the two defense giants have racked up:
- Saudi Arabia has inked a $29.4 billion deal with BA for 84 new F-15 fighters, with deliveries beginning in 2015. The contract also includes upgrades to 70 existing aircraft.
- Boeing held on to a $3.5 billion contract for the U.S. Ground-Based Midcourse Defense (GMD) missile shield. The company had to beat back a challenge from LMT and Raytheon (NYSE:RTN) to secure the award.
- Boeing and partner Bell Helicopter received a $181 million contract for more work on the V-22.
- Boeing’s biggest hedge is on the nondefense side of the house, where a flurry of big deals in 2011 has the company holding a backlog of some $270 billion in commercial aircraft orders.
- Japan ordered 42 of LMT’s stealthy F-35 Joint Strike Fighters in a contract that could be worth as much as $20 billion over the next 20 years. LMT’s Lightning II beat out Boeing’s F-18 Super Hornet and BAE’s (PINK:BAESY) Eurofighter Typhoon.
- The United Arab Emirates ordered two of LMT’s Terminal High Altitude Area Defense (THAAD) missile-defense systems. The deal, which represents the first foreign military sale of the sophisticated system, could be worth nearly $2 billion.
- LMT inked a deal that could be worth as much as $2 billion with the National Science Foundation to operate and maintain the agency’s Antarctic research infrastructure.
- Lockheed Martin nabbed a $606 million contract with the U.S. Army to provide advanced PAC-3 Patriot missile interceptors and ground support to Taiwan.
- LMT also sold a total of $1.4 billion in late-model F-16s to Oman and Iraq. Oman will receive 12 F-16 fighter aircraft, while Iraq will get 18.
In addition to these recent deals, both companies have solid fundamentals. With a market cap of $55.4 billion, Boeing has a price-earnings-to-growth (PEG) ratio of 1.53, indicating it may be overvalued (1.00 indicates fair value). At around $74.50, the stock is trading more than 30% above its 52-week low of last July. With a one-year return of 15%, BA has a current dividend yield of 2.3%. Keep an eye on the balance sheet: Boeing has operating cash flow of $2.2 billion and levered-free cash flow of –$1.8 billion.
Lockheed Martin has a market cap of $26.7 billion and a PEG ratio of 1.4. At around $82.50, LMT is trading 24% above its 52-week low of August. With a one-year return of 23%, the stock has a current dividend yield of 3.9%. Lockheed Martin has operating cash flow of $3.2 billion and levered free cash flow of $2.8 billion.
Clearly, both companies have serious exposure to defense cuts, which will weigh on earnings for the near term. However, Boeing’s commercial aircraft business is its ticket to riding out the defense procurement slump.
Lockheed Martin’s task is a little tougher than Boeing’s, since a lot of LMT’s nondefense sales come from civilian federal agencies, which are also facing the budget knife. Still, global demand for advanced weapon systems is expected to remain strong, exacerbated by tensions in the Middle East and the leadership transition in North Korea.
Bottom line: A long strategy on these two defense stocks should payoff down the road — and their healthy dividends don’t hurt either.
As of this writing, Susan J. Aluise did not hold a position in any of the stocks named here.