Grading 6 Defense Contractors After the Farnborough Air Show

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:

1. Boeing

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.

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.

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