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Stock Strategist Industry Reports

Defense Stocks: Value Investing or Value Traps?

Despite slowing defense spending, some firms have strong growth prospects.

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Trading at low multiples, many defense stocks appear to offer a good entry point for long-term investing. While we caution that in many instances the multiples are justified by poor earnings growth brought on by a weak defense budget outlook, a few defense names such as  Lockheed Martin (LMT),  Raytheon (RTN),  Alliant Techsystems (ATK), and  SAIC Inc (SAI) appear to be underpriced relative to their growth prospects and offer decent upside.

Defense Budget Outlook
After years of expansion following 9/11, the United States defense budget is slowing down in response to troop withdrawal from Iraq and as the government tries to shrink the size of the federal deficit through defense cuts. The U.S. defense budget comprises the base budget, which funds everyday activities of the armed forces, and the supplemental budget, which provides for special situations like the ongoing war efforts in Iraq and Afghanistan. The long-term health of defense firms is linked to changes in the level and mix of the base budget.

The outlook for the base budget is challenging as the government tries to find ways to reduce the budget deficit. Current Department of Defense projections forecast a low-single-digit nominal growth (nearly zero real growth) over the next five years. Further, defense contracts mostly flow from the procurement and research part of the base budget (called investment accounts, typically about 40% of the base), which will grow even slower than the base budget as the people-related costs (salaries and health-care expenses) outgrow other items. In such an environment defense revenue will demonstrate minimal growth.

Even as the federal government looks for ways to cut down defense spending, the responsibilities of the U.S. armed forces show no signs of slowing, and U.S. interests in the Far East, South Asia, and the Middle East are continually challenged by rising powers like China and nonstate factors like al-Qaeda and the Taliban. Quite unlike the "peace dividend" years following the collapse of the Soviet Union, the U.S. faces a litany of security challenges, and the DoD seeks to overcome these despite a declining budget environment. Forced to make do with less, we think DoD will try to pay less for regular contracts while shifting project risk in new platforms to defense contractors. Such actions will chip away at margins, even as lower sales weaken operating margin due to operating leverage. Poor sales growth and weak margin progress foretell little earnings growth, and the low multiple for most defense stocks is a direct consequence of this expectation.

While a negative headwind persists, a few bright spots in the defense arena are being unfairly punished as the market paints every defense stock with the same brush. These firms have, in our opinion, much stronger earnings growth prospects relative to the multiple the market is currently paying.

Our Picks

Lockheed Martin LMT 
We like Lockheed's competitive position in the defense industry since it derives about 80% of sales in monopolistic or rationally duopolistic markets. This is important in the defense industry since the DoD is the primary customer, and only supplier power derived from monopoly or rational duopoly market structures can offset such strong customer power. Thus, Lockheed's return on invested capital averaged 17% during the last five years. At the current price the stock yields 3.7%, as the firm spends around $1.1 billion or $3 per share in dividends. This works out to around 35% of the firm's nearly $3 billion of annual free cash flow. With only $650 million in debt due in the next five years, few acquisition candidates, and a strong cash cushion, we think Lockheed's dividend is safe and could improve further. Despite the flat defense budget, Lockheed's earnings per share will improve in the future as higher F-35 demand will power sales growth, even at flat operating margins. Further, the firm's pension, which derailed earnings in the last couple of years, will improve starting in 2012, driving further earnings growth.

Raytheon RTN 
We believe narrow-moat Raytheon offers good value at less than 10 times earnings estimates for 2011 and a 3.5% dividend yield. The company's focus on innovation has helped it secure more than 15,000 total contracts. While 119 of these contracts represent 50% of sales, we believe the company is fairly insulated as no contract represents more than 5% of revenue. Furthermore, our assumptions call for less than 4% revenue growth and slight improvement in operating margin. With cash flow from operations of nearly $2 billion per year, the company has ample flexibility to enhance shareholder value over time. Growth in international sales, which represent 23% of sales, could slow if the U.S. government delays approval for product sales resulting from recent unrest in the Middle East. However, our view is that the long-term budget pressure in the U.S. could make sales to allies more likely in order to maintain global presence with limited (U.S.) funds.

SAIC offers strong upside for investors, in our opinion, as the stock is trading at close to 80% of our fair value estimate. The firm's share price has been roughly flat since it went public in 2006, yet earnings per share has increased over 50%. After weaker results in the current year and next year, we expect earnings to march higher in 2013 and beyond. SAIC trades at defense industry multiples, yet approximately half of its portfolio is exposed to higher-growth areas such as cyber security and nondefense markets such as energy and health care. Our valuation only assumes about 4% annual sales growth and margin degradation over our forecast horizon. A strong balance sheet and commitment to use its healthy free cash flow on share repurchases should eventually push the stock higher.

Alliant Techsystems ATK
Alliant faces a number of short-term headwinds, but we believe the shares represent strong long-term value. Alliant is a leader in the manufacture of solid rocket propellant used in vehicles such as the space shuttle. With this program winding down, Alliant will likely face near-term revenue pressure in this segment. However, we believe the firm is well-positioned to compete for a future heavy-lift vehicle that NASA is contemplating. Alliant is also entrenched as a leading maker of bullets and ammunition for the military but is facing an upcoming recompete on a contract and higher commodity costs. However, the firm's recent growth in the civilian market for ammunition and accessories should more than offset near-term cost pressures and allow for long-term growth. Finally, recent wins to make composite products for the F-35 fighter and A350 commercial aircraft provide solid long-term growth as these programs ramp up, even while near-term costs are incurred. With the stock trading at only about 75% of our fair value estimate and also offering a 1.2% dividend yield, we believe investors will be well-compensated to own the shares over time.

Senior Analyst Rick Tauber and Equity Analyst Neal Dihora also contributed to this article.

Anil Daka does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.