Despite enduring myriad business and political headwinds in 2013, defense stocks not only survived, but thrived — and investors are the better for it. Defense stocks have gained an average of more than 50% over the past year, and most are trading at 52-week highs.
Deep defense cuts may have driven down revenue year-over-year for the Pentagon’s top contractors, while fiscal cliff fears and sequestration — the $85 billion in automatic, across-the-board federal spending cuts that kicked in last March — looked certain to add insult to injury.
But give the top defense stocks a lot of well-earned credit: they boosted margins by cutting costs aggressively. Many companies beefed up international sales and focused on growing high-growth businesses like commercial aircraft and components, which are not dependent on federal government spending.
And here’s more good news for defense stocks: the $1.1 trillion omnibus spending measure President Obama signed into law last Friday gives the Pentagon nearly $93 billion to buy weapons and another $63 billion for research and development.
Obviously the defense sector will continue to face headwinds as Pentagon spending wanes, but the best defense stocks will continue to take good care of their shareholders for years to come. Here are four defense stocks that could pay off big in 2014.
General Dynamics (GD)
General Dynamics’ (GD) fourth-quarter earnings per share beat the street by a penny at $1.76 per share on Wednesday; revenue edged up to $8.1 billion over the consensus $7.99 billion. The company also improved operating margins in every unit but marine systems. GD stock emerged as perhaps the biggest winner in the defense bill as lawmakers spared the U.S. Navy’s Virginia Class Attack Submarine.
General Dynamics’ Electric Boat division and co-contractor Huntington-Ingalls Newport News Shipbuilding (HII) are building the next-generation subs, which cost $3.2 billion apiece, at a total program cost of $93 billion. Lawmakers also ponied up $90 million to buy more M1 Abrams tanks — even though the Army says it doesn’t want any more of them.
But the winning play for GD stock investors is the company’s profitable Gulfstream aircraft business, which CEO Phebe Novakovic said Wednesday is the “primary growth engine” for the company’s earnings and revenue.
GD stock trades at 13.7 times forward earnings and has a price-to-earnings-growth (PEG) ratio of 2, which suggests it’s overvalued. GD’s current dividend yield is 2.3%. Despite the high valuation and average yield, this is still one of the best defense stocks out there.
United Technologies (UTX)
United Technologies (UTX), which also reported fourth quarter earnings on Wednesday, beat on earnings and missed on revenue in the fourth quarter. The $1.58 EPS handily beat the $1.53 Wall Street expected, although its $16.76 billion in revenue missed analysts’ estimate of $17.09 billion.
The defense bill added in $72 million for more Black Hawk helicopters, which are manufactured by UTX’s Sikorsky unit. Still, diversified business lines are the biggest strength as Pentagon spending declines. UTX’s Otis elevator business and its Pratt & Whitney aircraft engines unit were both winners in the quarter and remain sources of strength for the company in 2014.
The big winner for UTX stock in the fourth quarter: Sales of commercial aircraft parts in the company’s UTC Aerospace unit, which rose a whopping 19%. UTX has a market cap of $105.3 billion and the lowest price-to-earnings growth (PEG) ratio in this group at 1.52.
UTX’s forward P/E of 17 is higher than average among defense stocks, and second only to Boeing’s 19. The current dividend yield of 2.1% is comparable to other defense stocks. Despite that valuation, UTX stock remains a solid pick thanks to its diversification.
Lockheed Martin (LMT)
Lockheed Martin (LMT), which reported earnings on Thursday morning, beat the Street on the top and bottom lines — despite the fact that its fourth-quarter profit was 19% lower than a year earlier. Earnings of $2.38 per share easily topped the consensus $2.11, while revenue of $11.53 billion trumped the $11.34 billion forecast.
That’s not bad for the largest pure-play defense stock — and it illustrates the value of LMT’s relentless cost-cutting efforts. The defense bill helped LMT in two important ways:
First, the troubled and pricey F-35 Lightning II fighter emerged largely unscathed for 2014 and 2015. The bill funded 68 of the sophisticated fighter jets over the next two years and maintained the total order at 2,443. Second, the bill earmarks $333.5 million for a new Air Force search and rescue helicopter — a joint venture between LMT and Sikorsky was the sole bidder on the program.
With a $48.8 billion market cap, LMT trades at 15 times forward earnings and has a price to earnings growth (PEG) ratio of 2.27, which is in line with most other defense stocks. Its current dividend yield is the highest among the top six defense stocks at 3.5%.
Northrop Grumman (NOC)
Northrop Grumman’s (NOC) aggressive cost-cutting efforts should go a long way toward helping it turn in a solid fourth-quarter earnings report on Jan. 30. NOC blew away analysts’ estimates when it last reported earnings on Oct. 23, with earnings of $2.14 per share, beating the Street by 32 cents; full-year earnings are expected to be $8.15 per share.
The Pentagon may be less enamored with big drones these days, but Northrop Grumman and its Congressional supporters have blocked Air Force efforts to retire the fleet of Global Hawks. In fact, the defense bill adds $10 million to study whether sensors from the legendary U2 spy plane could be fitted onto the massive unmanned aerial vehicle.
NOC also benefits from lawmakers’ commitment to the F-35 because it produces the AN/APG-81 Radar for the fighter jet; the company made $1 billion in subcontracting revenue on that program alone in 2012.
NOC stock has a lofty PEG ratio of 3.8, suggesting that the stock is overvalued. It trades at 14 times forward earnings and has a current dividend yield of 2.1%. Still, expect the cost-cutting to go a long way in 2014.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.