One fact was eerily clear for defense contractors gathered in England last week for the biennial Farnborough Air Show: The industry is bracing for trouble. But amid the thunderheads that loom are a few points of light for the sector’s investors.
First the bad news: Attendees characterized the year’s biggest defense, aerospace and aviation forum (it alternates years with the Paris Air Show) as “subdued.” Some high-profile contractors like Northrop Grumman (NYSE:NOC) chose not to exhibit at all.
Even the major contractors that were there — including Lockheed Martin (NYSE:LMT), Raytheon (NYSE:RTN), General Dynamics (NYSE:GD), United Technologies (NYSE:UTX) and Boeing (NYSE:BA) — were bracing for slashed defense spending on both sides of the Atlantic.
Here’s why: Defense contractors face $500 billion in U.S. cuts — part of the $1.2 trillion in across-the-board federal budget reductions that will take effect on Jan. 2, if Republicans and Democrats can’t agree on an alternative plan to trim the nation’s deficit. Any automatic cuts would be in addition to nearly $500 billion in reductions over the next decade that President Obama announced last year.
It gets worse. Before the air show kicked off last week, the U.K. Army announced defense cuts of its own. Although those focused on eliminating 20,000 troops and 17 major divisions over the next eight years, analysts say the service also likely will reduce equipment — potentially including systems by LMT, BA and NOC.
Add to that the eurozone debt crisis as well as the U.S. “fiscal cliff” of across-the-board spending reductions and the expiration of Bush-era tax cuts, and the prospects for defense contractors begins to look bleak indeed.
Still, it’s hardly the time to give up defense contractors for dead, as a PriceWaterhouseCoopers report released at Farnborough illustrates.
Defense and aerospace companies can ride out the turbulence through innovation, efficient cost and supply chain management and better integrating programs with customer needs and priorities. Beefing up global operations and diversifying product offerings are also emerging as winning strategies for defense companies, the PwC report said.
Here are six major defense contractors that deserve a look after Farnborough, graded by the opportunity they offer investors now:
Boeing’s strong presence in commercial aircraft will be a big boon for the company over the long haul — particularly given its aggressive production targets in the next few years. Further evidence of the company’s strategy shift emerged on Monday, when Boeing said it would withdraw from competing for the $3 billion U.S. Air Force Launch Test Range Integrated Support contract to pursue other priorities.
With a market cap of nearly $55 billion, BA is trading around $73, 29% above its 52-week low last August. Its price-to-earnings growth (PEG) ratio of nearly 1.5 suggests the stock is overvalued, but it’s in line with the PEGs of most of its peers. It has a forward P/E of about 13 and a current dividend yield of 2.4%.
Grade: B+. On the strength of its commercial airplanes business, I rank BA the top stock in the sector. BA’s commercial aircraft sales got a lot of lift at Farnborough. The company isn’t dumping defense, but its shift in priorities is one reason BA stock should be able to maintain much of its altitude for the foreseeable future.
2. General Dynamics
GD is clearly a very big gun in the defense sector. Of the company’s four divisions, count on two of them — combat systems and marine systems — to take a big hit on defense cuts. Its information-services business appears to be more solid, with the company inking an eight-year, $19 million deal with the FBI last week for IT management and security.
But the biggest opportunity for General Dynamics is in aerospace, where its Gulfstream business jets account for more than 20% of revenue. The value of vendor partnerships isn’t lost on GD. The company has teamed with European aerospace giant EADS to submit a joint bid to the Department of Homeland Security for border-control systems.
With a market cap of $23 billion, GD is trading around $64, 18% above its 52-week low last October. It has a PEG ratio of 1.2 and a forward P/E of less than 9, which is attractive in this sector. It has a current dividend yield of 3.2%.
Grade: B. The Gulfstream unit provides valuable diversification for GD, particularly in light of big combat and maritime systems cuts. In its partnership with Airbus parent EADS, GD seems poised to strengthen its competitive position against rival Boeing.
3. United Technologies
UTX’s recent acquisition of Goodrich expands its footprint in commercial aircraft while giving its restructured aerospace division a new home in North Carolina — a “right-to-work” state with lower labor costs. But it can still win defense business. Its Sikorsky Aircraft unit penned a five-year, $8.5 billion deal last week to build 653 helicopters for the U.S. Army and Navy.
With a market cap of $67 billion, UTX is trading around $73.50, 10% above its 52-week low last August. It has a PEG ratio of 1.1 (meaning it’s valued about right). It has a forward P/E of over 13, which is a little high in this sector. Its current dividend yield is 2.9%.
Grade: B-. UTX gains a big win with Goodrich and the labor savings in North Carolina. The Sikorsky deal is a promising development, and the company’s Pratt & Whitney engines will benefit from the boost in aircraft production.