General Dynamics’ Secret Weapon

by Jonathan Berr | September 24, 2012 9:44 am

Shares of Lockheed Martin (NYSE:LMT[1]), Raytheon (NYSE:RTN[2]) and Northrop Grumman (NYSE:NOC[3]), three of the largest defense contractors, are trading above their 52-week target prices after surging by double digits this year. But General Dynamics (NYSE:GD[4]), a maker of warships and combat vehicles, is more attractively valued than its rivals even as Congress tries to avoid pushing the U.S. economy over the fiscal cliff.

The valuations many of these stocks are out of whack. Lockheed, maker of the F-16, recently traded at $91.54, well ahead of analysts’ price target $87.60. Missile-maker Raytheon recently traded hands at $58.03, beating Wall Street’s $55.63 forecast. Northrop, whose products include the Global Hawk drone, was valued at about $4 higher than analysts’ $63.50 expectations.

General Dynamics is in Wall Street’s doghouse after it lowered its earnings outlook during its latest earnings report. The contractor, though, may have been overly conservative. Analysts have an average price target on the stock is $73.71, about 10% above where it recently traded.

Though Lockheed, Raytheon and Northrop have civilian businesses such as air-traffic control, government info-tech and space systems, it seems unlikely that these operations will grow fast enough to offset the cutbacks in Pentagon spending even if, as many expect, the fiscal cliff will be avoided.

Foreign government sales will help make up the shortfall, but given the worldwide economic slowdown, defense budgets are being cut across the globe. The outlook for contractors will be challenging regardless of who is elected president in the U.S.

Bethesda, Md.-based Lockheed is facing increased pressure from the government to improve the performance of its F-35 Joint Strike Fighter, the most expensive weapons system in history. Major General Christopher Bogdan,[5] the incoming F-35 acquisition chief, was recently quoted in the press saying that Lockheed’s management of the program was the worst he’s ever seen. Pentagon officials aren’t about to let up on the company.

“The Pentagon has about had it with them,” said Richard Aboulafia, an aerospace analyst with the Teal Group, in an interview. “Some of the problems [with the F-35] ‘’is due to the Pentagon’s changing requirements. But Lockheed is really under the gun.”

Firing Lockheed from the F-35 program — projected to cost $395.7 billion — seems unlikely at this point, given the time spent developing the aircraft and money involved. The company’s profit margins, though, are going to get squeezed hard.

“There are not a lot of choices in tactical aircraft,” Aboulafia said. “It’s too big to fail.”

Northrop, based in Los Angeles, is a key subcontractor on the F-35, so it’s also facing increased pressure from the Pentagon to hold the line on costs. The company is known for its drones that have been deployed in the war against terrorism. Though civilian interest in drones is growing[6], Teal analyst Phil Finnegan cautions that that market may take years to develop. Moreover, those unmanned aircraft will cost less than their military counterparts and, therefore, wouldn’t be as profitable a market for many defense contractors to pursue.

Waltham, Mass.-based Raytheon is under fire for delays in a multibillion dollar contract[7] to operate current and future global positioning satellites. Earlier this year, the Pentagon held up $621 million in payments to the company for advanced air-to-air missiles for the Navy and Air Force because Raytheon had fallen behind schedule[8].

That leaves us with General Dynamics, which is a member of InvestorPlace‘s Real America Index[9], representing the state of Virginia[10]. While GD is also no stranger to cost overruns and delays, the company has one asset that its rivals don’t: Gulfstream.

The business jet is the preferred mode of transportation for corporate execs, millionaires and billionaires who either can’t or won’t fly commercial for logistical or security reasons. GD’s aerospace business, which includes Gulfstream, routinely posts the best performance of any of the company’s divisions. The new large-cabin Gulfstream G650 will get more orders once deliveries begin at year-end.

General Dynamics also is a compelling value, trading at a price-to-earnings multiple of 9.67, near its five-year low, according to Reuters. Revenue in the current quarter will rise 2.4%, better than its rivals.

Jonathan Berr does not own shares of the listed stocks. Follow him on Twitter @jdberr.

  1. LMT:
  2. RTN:
  3. NOC:
  4. GD:
  5. Major General Christopher Bogdan,:
  6. civilian interest in drones is growing:
  7. a multibillion dollar contract:
  8. Raytheon had fallen behind schedule:
  9. Real America Index:
  10. state of Virginia:

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