With the S&P 500 index trading at a price-earnings-ratio of 35x, the broad markets look stretched in the near term. However, there are pockets of value in the markets. I believe that certain stocks and sectors, such as defense stocks, will outperform the market in the coming quarters.
The defense sector has not participated in the market rally. The iShares U.S. Aerospace & Defense ETF (BATS:ITA) has declined by 25% so far this year.
However, companies in the defense sector continue to grow and add to their order backlog. It’s therefore good time to consider exposure to the sector. The U.S. defense sector is expected to grow with a compound annual growth rate of 5% between now and 2025. In addition, defense companies will benefit from sales to the allies of the United States.
Given the factor of valuation and the growth outlook, defense stocks are worth holding in the portfolio.
These four defense stocks have been underperformers in the last year, but have the potential to deliver healthy returns in the coming quarters.
- Lockheed Martin (NYSE:LMT)
- Northrop Grumman (NYSE:NOC)
- Heico Corporation (NYSE:HEI)
- Aerojet Rocketdyne (NYSE:AJRD)
Defense Stocks to Buy: Lockheed Martin (LMT)
When it comes to defense stocks, LMT stock is my top choice. The stock has been sideways for almost one year. However, LMT stock does offer investors an attractive annual dividend of $10.40.
In addition, I believe that valuations are attractive and the stock is likely to trend higher in the coming quarters.
I like LMT stock from a revenue and cash flow visibility perspective. For the second quarter, the company reported an order backlog of $150 billion. This will ensure that cash flows remain robust and dividends sustain.
The company order book from international markets is likely to swell. By December, the U.S. and UAE are likely to reach an initial agreement for the sale of F-35 fighters. The sale of 40 F-35A’s spare parts, munitions and training for an estimated cost of $6.58 billion has been approved for Switzerland. A large arm deal with Taiwan is also on the cards. Therefore, Lockheed Martin stands to gain from sales to the U.S. government and also to the allies.
Considering these factors, I would certainly consider investment in LMT stock, which currently trades at a forward P/E ratio of 16x.
Northrop Grumman (NOC)
NOC stock has been an underperformer in the last year, trended lower by more than 12%. However, the 1.6% dividend yield stock is likely to bounce-back in the coming quartets.
According to RBC Capital Markets, the stock is likely to be an outperformer with a price target of $391. This implies a potential upside of 23% from current levels. Even a broader consensus of 20 analysts points to a potential upside of 24%.
From a business perspective, the company has a robust order backlog of $70 billion. Post the second quarter, the company also won a $13.3 billion Air Force missile contract. As orders flow, there is a clear revenue and cash flow visibility.
For the first half of 2020, the company reported a robust revenue growth of 11% in the space systems segment. Northrop Grumman has doubled the satellite factory capacity earlier this year. This is an indication of potentially sustained growth in this segment.
Overall, the company has strong fundamentals, a robust order backlog and healthy free cash flows. Shareholder value creation in the coming quarters is likely through stock upside and dividends.
Heico Corporation (HEI)
HEI stock is among the lesser-known names among defense stocks. However, I believe that the company has long-term growth potential and HEI stock can be a potential value creator.
In the defense sector, the company offers products and services that include component repair and return, build-to-print-manufacturing and reverse engineering, among others. Further, the company is also a provider of aerospace parts.
The important point to note here is that the company has certification from the likes of Lockheed Martin, Northrop Grumman, Pratt & Whitney and Airbus Military.
From an expansion perspective, Heico has pursued aggressive inorganic growth. For the current year, the company has acquired six companies. These acquisitions are likely to help in delivering growth coupled with driving innovation.
Aerojet Rocketdyne (AJRD)
AJRD stock is another name that has been upgraded by RBC Capital Markets. The stock currently trades near $41 and RBC has a price target of $54. This implies a potential upside of 31.7% from current levels.
RBC’s Michael Eisen believes that “position as the leading propulsion provider aligns the product portfolio with the defense verticals most likely to reap the benefits of sustained support in the current budget environment.”
It was recently reported that the U.S. military is eyeing new generation of space weapons. Focus in this area in the coming years is likely to benefit Aerojet Rocketdyne. The company’s next generation of growth programs includes hypersonic and space exploration.
The company’s propulsion products supported the launch of USSF-7 mission for the U.S. Space Force. NASA’s Mars 2020 mission with the Perseverance Rover is also being powered by Aerojet Rocketdyne propulsion system.
From a revenue perspective, Aerojet Rocketdyne reported an order backlog of $6.8 billion as of the second quarter. The company has a track record of positive FCF. The backlog ensures that EBITDA and cash flows remain strong.
Overall, the sideways to lower stock movement is a good opportunity to accumulate AJRD stock. Once the defense sector is back in favor, AJRD stock is likely to be a performer.
On the date of publication, Faisal Humayun did not have (either directly or indirectly) any positions in any of the securities mentioned in this article.
Faisal Humayun is a senior research analyst with 12 years of industry experience in the field of credit research, equity research and financial modeling. Faisal has authored over 1,500 stock specific articles with focus on the technology, energy and commodities sector. As of this writing, Faisal Humayun did not hold a position in any of the aforementioned securities.