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Defense Stocks Are Locked and Loaded

Don't kid yourself: The U.S. still needs to spend on defense


Shares of Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), Raytheon (NYSE:RTN) and General Dynamics (NYSE:GD) — four of the biggest defense contractors — have been hammered during the past three months because of concerns about looming cuts to the Pentagon budgets. The sell-off is probably overdone.

While it’s true that deep spending cuts are coming, the defense establishment is starting to say that Congressional bean counters are going too far. That point was echoed yesterday by Army Gen. Martin Dempsey, who is slated to become the next Chairman of the Joint Chiefs of Staff, saying, “national security didn’t cause the debt crisis nor will it solve it.”

Earlier this year, President Barack Obama proposed $400 billion in cuts over the next 12 years. Members of Congress are seeking $800 billion to $1 trillion in cuts during the next decade, a goal that Dempsey said would be difficult to achieve. He is right, of course.

Lockheed, which has been slashing its work force as Pentagon funds have dried up, seems to be best situated to weather the downturn. Also, the stock is cheap, trading at a multiple of 10.42. It has surged nearly 13% this year — though it has given back much of these gains — and recently posted stronger-than-expected earnings. The Bethesda, Md.-based company also boosted its guidance. Wall Street has an average price target of $85 on the stock.

Northrop Grumman and General Dynamics are down 2% this year. Both firms missed Wall Street expectations for revenue in quarterly earnings reported today but exceeded consensus for profit. The contractors raised their profit expectations for 2011. Wall Street has an average price target on Northrop of $70, ahead of the $65.40 level where it trades now, and $84.63 on General Dynamics. Northrop and General Dynamics trade at multiples of about 9.

Wall Street remains bullish on Raytheon, as well, giving it a mean target of $56.47, ahead of the $45.40 where it trades now. Shares of the Massachusetts-based company are off 2% this year. It is scheduled to report earnings Thursday. Analysts are expecting profit of $1.16 on revenue of $6.19 billion. Shares of Raytheon are cheap as well, trading at 9.45 multiple.

Despite all of the bluster about cutting the budget, the defense contractors have many things in their favor. First of all, they are major employers in many states, with hundreds of thousands of workers. That gives them huge political clout, even though it is diminished from where it used to be.

The Pentagon also needs to replace equipment, such as fighter jets, that has become worn out because of the wars in Iraq and Afghanistan. The Pentagon also has a continual need for spare parts and servicing, though there has been waste found in these processes. Defense contractors also are huge exporters, selling more than $77 billion worth of products overseas in 2010, according to the Aerospace Industries Association.

Moreover, defense contractors are more diversified than many investors realize. Take Lockheed Martin. In addition to being the world’s largest defense contractor, the company is a major player in the civil aviation sector, supporting 60% of the world’s commercial air traffic and 80% of the managed oceanic traffic. The company’s other civilian customers include the Department of Homeland Security, the Federal Trade Commission and the U.S. Department of Housing and Urban Development.

Northrop Grumman, which makes Predator drones, also is a major player in health information technology and educational assessments. Raytheon, the top missile maker, provides corporate training. General Dynamics, which makes military ships, is the parent of corporate jet maker Gulfstream.

Defense contractors are well worth the risk for most investors. Cost cutting might be all the rage, but security threats are too costly too ignore.

Jonathan Berr doesn’t own shares of the companies listed.

Article printed from InvestorPlace Media,

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