A good barometer of where defense stocks are going has always been the temperature of global geopolitical tensions. And the heat’s been on the rise for several years, as measured by global military expenditure.
In 2019, global military expenditure was $1.917 trillion. That increased to $1.981 trillion in 2020, the highest level since 1988, growing 9.3% higher from 2011. I believe that this spending trend is here to stay and it makes defense stocks attractive.
Recently, the International Monetary Fund also warned that there are growing signs of poverty, unrest and geopolitical tensions. With the Taliban taking control of Afghanistan, there is an additional concern in emerging Asia. Further, tensions between China and U.S. have sustained. The Middle East also remains a hotbed of conflict with Israel and Iran being the current focus of attention.
Given that there are several nuclear powers engaged in conflict, a full-fledged war seems unlikely. However, countries will continue to ramp-up their defense capabilities.
It therefore makes sense to consider exposure to defense stocks. It’s also worth noting that the defense sector is relatively immune to economic shocks. Even with the pandemic, the global military expenditures increased. This makes defense stocks attractive in any economic scenario.
Let’s talk about seven defense stocks that are worth considering for the medium to long term.
- Rada Electronic Industries (NASDAQ:RADA)
- AAR (NYSE:AIR)
- Lockheed Martin (NYSE:LMT)
- Northrop Grumman (NYSE:NOC)
- Kratos Defense & Security Solutions (NASDAQ:KTOS)
- Raytheon Technologies (NYSE:RTX)
- L3Harris Technologies (NYSE:LHX)
Defense Stocks to Buy as Geopolitical Tensions Heat Up: Rada Electronic Industries (RADA)
Let me start with a defense stock that seems to be flying under the radar and looks promising for the long-term. In the last 12-months, shares of Rada Electronic Industries have trended higher by 52%. However, I would not be surprised if RADA stock delivers multi-fold returns in the next few years.
As an overview, Rada is a defense-technology company with a focus on tactical radars. The company believe that the total addressable market for tactical radars is in excess of $6.0 billion. Therefore, there is ample scope for growth.
Top-line growth has already been robust for the company. For 2020, Rada reported revenue growth of 72% to $76 million. For the current year, the company has guided for revenue of $120 million.
It’s worth noting that the company had an order intake of $56 million for the first half of 2021. On a year-on-year basis, order intake was 37% higher. If this momentum sustains, Rada is well positioned for healthy top-line growth in the coming years.
Recently, Rada and Alpha Design Technologies signed an agreement for a joint venture in India. That country is ramping-up defense expenditure as tensions continue with China and Pakistan.
Rada believes that it has a market share of around 10% in the tactical radar segment. However, over the next five years, the company is targeting a market share of 50%. Given the growth trajectory and the market size, RADA stock is worth holding in the portfolio.
AAR (AIR)
AAR is another interesting name among small-cap defense stocks. Even after an upside of 65% in the last 12-months, AIR stock looks attractive at a forward price-to-earnings-ratio of 13.8.
As an overview, AAR is a provider of aviation service to the commercial and government sector globally. This includes MRO service and parts supply and integrated solutions. In 2020, the company reported 38% of revenue from the government sector. However, sales to government and defense sector increased to 51% in 2021.
This is an indication of the company’s focus, which is likely to deliver results in the long-term. With the downturn in commercial aviation, the company’s investment is likely to remain high in the defense segment. Importantly, as defense revenue growth, the company is positioned for relatively higher EBITDA margin. Recently, DefenseNews included the company among the top-100 defense companies.
The Pentagon is a key client and the company has made inroads in the defense sector in Japan, Netherlands and U.K. Clearly, with international presence, there is a big addressable market for the company.
Overall, AIR stock looks good for further upside after some consolidation. As operating cash flows increase, the company will be positioned for further investment and expansion.
Defense Stocks to Buy: Lockheed Martin (LMT)
Among the bigger names in the defense sector, Lockheed Martin looks attractive. Besides the growth potential, LMT stock offers an annualized dividend of $10.40. Further, the broad markets look stretched and the stock has a relatively low beta.
Lockheed Martin has an order backlog that’s in excess of $140 billion. This provides clear cash flow visibility and the company’s order intake has been robust.
For the current year, the company has guided for operating cash flow of $8.9 billion. Even if OCF is stable around these levels, the company has ample flexibility for investments and shareholder value creation.
It’s also worth noting that Lockheed has been boosting its international presence. In the coming years, the company’s order backlog is likely to remain strong with most allies falling short of the NATO defense spending target. In June 2021, Lockheed Martin won an order worth $6.5 billion from Switzerland for delivery of F-35 fighters.
The company’s space segment is another long-term growth catalyst. Aeronautics, rotary and mission system remain the key top-line drivers. However, the space segment has witnessed healthy growth in the recent past.
Overall, LMT stock is a quality name for income investors. Further, the company is likely to witness steady earnings growth with higher global defense spending.
Northrop Grumman (NOC)
Northrop Grumman is another quality name among defense stocks from a dividend perspective. NOC stock currently offers an annualized dividend of $6.28. Additionally, the stock has trended higher by 19% for year-to-date 2021.
For Q2 2021, Northrop reported sales growth of 3% to $9.2 billion. It’s worth noting that for the quarter, the company’s sale from space systems increased by 34% to $2.7 billion. Even for the first half of the year, space systems registered 32% YoY growth.
In terms of cash flow visibility, Northrop Grumman reported an order backlog of $76.6 billion for Q2 2021. Beyond the quarter, order inflow has remained robust.
The company last month won an order worth $3.86 billion for Minuteman III Intercontinental Ballistic Missile ground subsystems support. Another major contract in July was from NASA for moon living quarters. The order was worth $935 million.
Therefore, given the current backlog and the pace of order inflow, the company is well positioned to generate sustained free cash flows.
NOC stock also trades at a forward price-earnings ratio of 14.6. Valuations look attractive considering the dividend visibility. Furthermore, the stock has a low beta of 0.84 and is worth considering at a time when markets look edgy.
Defense Stocks to Buy: Kratos Defense & Security Solutions (KTOS)
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Kratos Defense is among the smaller names in the defense sector. However, KTOS stock holds immense potential in the long-term. In the recent past, the stock has been in a correction mode and this provides a good accumulation opportunity.
The company specializes in unmanned systems, satellite communications, cyber security/warfare, microwave electronics and missile defense, among others. Additionally, the company is involved in the next generation turbo jet and turbo fan engine development.
For Q2 2021, the company reported revenue growth of 20.4% on a YoY basis to $205.1 million. It’s worth noting that the company’s unmanned systems segment revenue surged by 43.6% to $60.3 million.
Eric DeMarco, Kratos’ president and CEO, has also guided for strong growth in the space and satellite business. Segment sales are likely to accelerate in Q4 2021 with “significant margin expansion.” The growth trajectory is expected to further accelerate in 2022.
Therefore, with organic growth and acquisition driven growth, KTOS stock seems attractive. The company is likely to remain free cash flow negative for the year. However, the immediate focus will be on top-line growth and incremental capital expenditure.
Overall, Kratos is operating in some interesting defense segments and the company’s order intake has been healthy. KTOS stock is therefore worth accumulating at current levels.
Raytheon Technologies (RTX)
Coming back to the big names in the industry, Raytheon is worth considering for the core portfolio. The stock is attractive for income investors with a current dividend yield of 2.43%.
At the same time, the stock has trended higher by 17.5% this year. Considering the fact that RTX stock trades at a forward P/E of 20.7x, I would not be surprised if there is further upside.
It’s worth noting that the company ended 2020 with a robust order backlog of $150 billion. This provides clear cash flow visibility.
Raytheon has also guided for sales growth at a CAGR of 6% to 7% through 2025. With a guidance for margin expansion, the company is positioned to generate healthy free cash flows. This makes RTX stock a potential addition to the list of dividend growth stocks.
Another important point to note is that Raytheon is working on segments that include hypersonics, electronic warfare, connected battlespace and next generation military aircraft. These segments are likely to be growth drivers in the coming years. For 2020, advanced technologies contributed to 5% of the defense segment revenue.
Further, the company’s missiles and defense segment is diversified from a geographical perspective. In 2020, the segment derived 47% revenue from international customers from 28 countries. Therefore, as defense spending increases globally, the company is well positioned to benefit.
Defense Stocks to Buy: L3Harris Technologies (LHX)
L3Harris Technologies is another name among defense stocks that’s attractive from a dividend and valuation perspective. The stock offers an annualized dividend of $4.08. Further, LHX stock trades at an attractive forward P/E of 17.7x.
As an overview, L3Harris operates as an aerospace and defense contractor with solutions for air, land, sea, space and cyber domains. As of April 2021, the company reported an order backlog of $21.7 billion. For the current year, the company has guided for revenue of $18.1 to $18.5 billion. Therefore, the current backlog provides a one-year forward cash flow visibility.
It’s also worth noting that L3Harris has guided for free cash flow of $2.8 billion to $2.9 billion for 2021. This provides ample headroom for dividend growth and continued share repurchase.
L3Harris has also undertaken a business transformation. The key objective is to focus on high margin and high growth business. Therefore, FCF upside is likely in the coming years. As a part of this transformation, the company sold its combat propulsion systems and military training division. The company has also signed an agreement to sell the electronics division for $185 million.
In the last six months, LHX stock has already trended 22% higher. However, considering the cash flow outlook and the valuation, further upside should be on the cards.
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. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
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.
