Investors in defense stocks have had their faith and patience tested during the endless acts of Washington’s “Political Theater of the Absurd” this year — slashed Pentagon budgets, fiscal cliff fears and sequestration — but many of the biggest names have still rewarded shareholders’ trust handsomely.
Consider the second-quarter earnings of the federal government’s top defense/aerospace contractors, including Boeing (BA), United Technologies (UTX), Lockheed Martin (LMT), and Northrop Grumman (NOC). They managed to weather budget woes that shaved revenues to the bone, as well as make operational adjustments that preserved margins and beat Wall Street expectations.
Other companies are hard-pressed on every side, and their heavy Pentagon exposure seems to make them top-heavy and at a risk of capsizing — but relentless cost control, emerging opportunities and battleship balance sheets give them extra protection from the tempest.
The market has seen how well these companies have rolled with adversity — and it has made its own adjustments. With upcoming third-quarter earnings likely to spark or spook defense stocks, here are three defense stocks to buy, and one to sell.
Buy: United Technologies
Thanks to the Pentagon’s decision to bring back most of its civilian employees sent home by the partial government shutdown, United Technologies (UTX) cancelled plans to furlough 4,000 employees from its Sikorsky Aircraft and Pratt & Whitney units who work on the Black Hawk helicopter program. That’s a strong signal that United Technologies plans to stay primed for business.
After second-quarter earnings, UTX raised the low end of its full-year guidance despite headwinds from the federal government’s sequestration — thanks to a massive restructuring effort that has made the company leaner and meaner. United Technologies has the benefit of a strong position in defense/aerospace, as well as diversification in the high-growth commercial aircraft sector — a market UTX further optimized by acquiring B.F. Goodrich last year.
Shareholders, however, might be happier about the company’s 10% increase in its fourth-quarter dividend — a move that brings the current yield near 2.3%.
The company’s consistently strong cash generation — combined with analyst estimates that the stock has a potential upside of about 13% for the next year — increases the attraction, as does the strong management team ably led by CEO Louis Chenevert.
Buy: Lockheed Martin
As the largest defense pure play, Lockheed Martin (LMT) seems like a logical sell choice at a time when much of the federal government is officially idled and Pentagon budgets are cratering.
The risk seems even more pronounced considering that more than 80% of LMT’s revenue in the fiscal second quarter came from federal sales — including major Pentagon contracts for the F-35 Lightning II Joint Strike Fighter, Littoral Combat Ship, Patriot Advanced Capability-3 missile and the AEGIS missile defense system.
But that’s only part of the story. Despite revenues falling by more 3% in the second quarter, operating profit and margins actually improved as the company cuts operating costs and boosts efficiency. On Monday, Lockheed Martin also scaled back its planned furloughs from 3,000 workers to 2,400 after the Pentagon ordered most employees back to work.
Another potential bright spot: international sales opportunities. South Korea’s rejection of low-bidder Boeing’s F-15 Silent Eagle for a planned 60-fighter jet procurement contract revives LMT’s fortunes for its F-35. It also doesn’t hurt that LMT’s current dividend is a stable and notable 4.3%.
Buy: Northrop Grumman
The government shutdown might delay cash changing hands between the Pentagon and its contractors, but booking that backlog is still pretty important. Northrop Grumman (NOC) managed to snag nearly $1.3 billion in defense contracts the Friday before acquisition officers closed the books.
Those deals include nearly $800 million to provide logistics support to Air Mobility Command aircraft at several U.S. air bases through September 2015 and a new $114 million contract to begin initial production of three new Lot 11 Block 20 Global Hawk drones. NOC also landed a new $227 million deal to design, develop and build the U.S. Navy an E-2D Advanced Hawkeye early warning aircraft that can be refueled in flight.
Another bright spot: The Affordable Care Act’s health insurance exchanges opened for business on Oct. 1 despite the government shutdown — amid reports of myriad glitches and constrained server capacity. NOC, which has deep expertise in healthcare IT (and won a contract in July to build and operate a new Web-based enterprise system for Tennessee) seems a great choice to boost its penetration in this sector now.
In the second quarter, Northrop Grumman increased its full-year EPS guidance despite revising revenue slightly downward to $24 billion. Cost-cutting is a huge priority at NOC, and the company has done a great job of raising profitability through layoffs and other measures. Northrop Grumman also has done a solid job of generating cash, most of which has been distributed to shareholders through share repurchases and dividends — its current yield is 2.6%.
Boeing’s (BA) strong run might not be completely finished, but in the weeks to come, shareholders are likely to start feeling the jet lag. BA’s silver bullet to ward off earnings threats from the federal budget wars has been its rock-solid commercial airplane unit, with sales and orders buoyed by innovative models like the 787 Dreamliner and great enthusiasm over the upcoming launches of the fuel-efficient 737 MAX and 777X.
But lately that bullet has started to show signs of tarnish: Persistent glitches with the company’s flagship Dreamliner, increasingly public criticisms by airline customers — and compensation demands for out-of-service aircraft — and even an admission from Commercial Airplanes Chief Randy Tinseth that the 787 needs to be more reliable.
Boeing’s biggest near-term hit besides losing the South Korea fighter jet deal? Rival Airbus snagged its first-ever order from Japan Airlines for 31 next-generation A350 jets — that ups the ante significantly in the all-important and high-growth Asian market. While Boeing pays a dividend, the 1.7% current yield is the slimmest among its major defense/aerospace peers. With all this turbulence and earnings on the horizon too, take profits in BA now.
Bottom Line: Expect greater volatility in all defense/aerospace stocks for the near term. At times like this, remember the sage words of Warren Buffett: “Be fearful when others are greedy and greedy when others are fearful.” And keep close tabs on your defense/aerospace holdings.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.