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Grading 6 Defense Contractors After the Farnborough Air Show

Looming defense cuts mean investors have to chose carefully

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4. Raytheon

The company that brought the defense sector the famed Patriot missile — and supplies high-profile systems like the Tomahawk and Sidewinder — is surprisingly well diversified. Because of its leadership in radar and military electronics, its components are part of literally thousands of Defense Department programs. Considering that those components provide less expensive ways to upgrade existing weapon systems, RTN should fare better than many contractors. It announced a $636 million U.S. Missile Defense Agency contract at Farnborough to continue work on an interceptor that can kill incoming ballistic missiles in space.

With a market cap of $18.6 billion, RTN is trading around $56, and it set a new 52-week high on July 10. It has a PEG ratio of 1.2 and a forward P/E of 10. Its current dividend yield is nearly 3.6%.

Grade: C+. Raytheon is more of a defense pure play and that’s its greatest vulnerability — and potentially its greatest strength. Because its components are found in some 8,000 military systems and many provide an affordable upgrade option for the Pentagon, RTN should come through the budget cuts better than some of its peers.

5. Lockheed Martin

The defense giant has cut payrolls lately to prepare for the sector’s downturn. LMT’s greatest risk is with its F-35 Lightning Joint Strike Fighter, which accounted for more than one-tenth of its revenue in 2010. The Pentagon will delay production of 179 of the jets over the next five years due to budget cuts.

On the upside, LMT has been able to find international buyers for the stealth jet: Japan, Israel and Norway have announced plans to buy the aircraft. LMT also has posted strong gains in its aeronautics unit, particularly with its Stalker drone.

With a market cap of $28.3 billion, LMT is trading at around $87 — 31% above its 52-week low last August. It has a PEG ratio of 1.8, indicating that the stock may be overvalued. It has a forward P/E of 11. Its current dividend yield is 4%.

Grade: C. The uncertain fate of the F-35 is a big challenge for LMT, and it will need to gain greater commitments from outside the U.S. to replace some of that lost revenue. LMT has had some successes, but it will need a lot more. It also will need to avoid more production delays and cost overruns if the stealth fighter is to survive.

6. Northrop Grumman

Among the biggest challenges facing NOC are cuts to LMT’s F-35, for which Northrop is a major partner. It also faces reductions in the Global Hawk drone program. However, NOC has an emerging opportunity because drones soon will be entering the commercial arena en masse. NOC has a strong position in secure IT and recently won a $108 million Air Force contract to upgrade cryptography on the nation’s intercontinental ballistic missile arsenal. Last week, NOC announced mine-hunting system contracts with Japan’s Maritime Self-Defense Force.

With a market cap of $16 billion, NOC is trading around $63.50 — 30% above its 52-week low last August. It has a PEG ratio of 2.6, indicating that the stock is overvalued. Its forward P/E is a very attractive 7, as is its 3.5% current dividend yield.

Grade: C-. NOC has a host of vulnerabilities, most stemming from its strong defense focus. The company likely will take a short-term PR hit on its money-saving decision not to exhibit at Farnborough. Still, I like the commercial drone opportunity as well as NOC’s expertise in secure information access and control. That said, I remain cautious on NOC in the near term.

As of this writing, Susan J. Aluise did not hold a position in any of the stocks named here.

Article printed from InvestorPlace Media,

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