Is Lockheed Martin the Best Defense Stock Heading into 2016?

January 4, 2016 |

Increasing geopolitical tensions will once again make defense stocks an attractive option in 2016. Lockheed Martin (NYSE: LMT), a leader in the defense industry, received promising news in late November when U.S. Deputy Defense Secretary Bob Work revealed that the Canadian government may allow the F-35 fighter jet to compete to replace the CF-18 jet, which has been the Canadian Force’s fighter aircraft since 1982. Future performance of LMT depends heavily on the performance of the F-35 program, and winning an additional contract in Canada would see Lockheed shareholders reap benefits in 2016 and beyond. But is Lockheed Martin the best value in the defense industry going into 2016? In this article, we compare Lockheed to two other major defense contractors, Raytheon (NYSE: RTN) and Northrop Grumman (NYSE: NOC). To begin our comparison, let’s take a look at each company, first plotted against the S&P Aerospace & Defense ETF(XAR), which will serve as a baseline and proxy for the aerospace and defense industry, and then each company on their own:
chart of defense stocks

Lockheed Martin

Share Price: $215.48

2014 Revenue: 45.6 billion

P/E : 19.38

45.48: Neither overbought nor underbought
all table

Raytheon

Share Price: 126.03

2014 Revenue: $22.8 billion

2014 EPS: $7.19

RSI: 55.77: Nearing overbought
raytheon chart

Northrop Grumman

Share Price: $187.95

2014 Revenue: $23.9 billion

2014 EPS: $9.90

P/E: 18.12

RSI: 57.10: Nearing overbought
northrop grumman chart

Shares of Lockheed Martin and Raytheon have performed similarly this year, with LMT returning 15.1% (13.3% higher than XAR) in the last 12 months, and RTN returning 15.5% (13.6% higher than XAR). Northrop Grumman was the real winner of 2015, returning 33.3% and beating the XAR by 31.4%.
table of all stocks

The three firms, who were top large cap defense contractors in 2015, are all trading with a similar P/E: LMT with 19.4, RTN with 18.4, and NOC with 18.1. And while Lockheed Martin has higher EPS vs both Northrop and Raytheon, its P/E is higher and its margins are notably lower, as shown in the table above, meaning it will need greater revenue growth than NOC and RTN to keep pace with EPS growth in 2016. All three firms compare favorably to the industry P/E of 22.2 and the industry net margin of 5.2%. With all three firms trading cheap relative to the industry, which are poised to break out in 2016?

Key Drivers

None of the firms are immune to global defense budget cuts or U.S budget sequestration. Instead, we will look at more firm-unique growth drivers and risks for each company below.

Lockheed Martin:

Lockheed’s future is intertwined with the success of the F-35 going forward. The F-35 program accounted for 20% of the company’s Aeronautics product revenue in Q3 2015, up 3% from last year. The F-35 is in government operational tests phases, and is projected to deliver at least 2,443 jets to the U.S. over the life of the program to replenish the government’s inventory objectives, giving Lockheed strong revenue visibility well into the next decade. LMT has already delivered 140 jets to the government with a backlog of 69 more from the U.S. and international partners. Lockheed’s total backlog as of Q3 was $71.7 billion dollars. The program could become more profitable as international sales agreements are reached. As mentioned above, the F-35 will be in competition with the Boeing Hornet, Rafale Dassault, and Eurofighter Typhoon to replace the aging CF-18 in Canada; if Lockheed wins, expect share prices to appreciate. The F-35 project though, has substantial risks: any further delays in the project could result in a drop in the share price, and congressional approval for future international sales could prove to be a significant obstacle to expanding the program beyond the U.S. border.

Another driver of Lockheed’s profitability in 2016 will be their recent acquisition of Sikorsky for $9.0 billion in cash. Last week Sikorsky won two U.S. Army contracts to support the military’s H-60 helicopters: the first support contract is worth $833 million and runs through the end of 2016, while the second weapons engineering contract is worth $106 million. Sikorsky earnings, which will be added to LMT financial statements when the acquisition is closed, should provide a boost to Lockheed earnings in 2016. Plotted below are past sales and eps, along with analyst estimates:

Another driver of Lockheed’s profitability in 2016 will be their recent acquisition of Sikorsky for $9.0 billion in cash. Last week Sikorsky won two U.S. Army contracts to support the military’s H-60 helicopters: the first support contract is worth $833 million and runs through the end of 2016, while the second weapons engineering contract is worth $106 million. Sikorsky earnings, which will be added to LMT financial statements when the acquisition is closed, should provide a boost to Lockheed earnings in 2016. Plotted below are past sales and eps, along with analyst estimates:
lockheed martin eps/sales

Raytheon:

In May of 2015, Raytheon acquired cybersecurity firm Websense for $1.9 billion, in what has so far been perceived as an expensive deal. The firm currently commands around $360 million in revenue, and Raytheon CFO Toby O’Brien claims that the venture could increase revenues to $500 million in the first year alone. Whether or not the acquisition is viewed as worthwhile in 2016 will be a major driver of Raytheon share price.

A second driver of Raytheon’s performance going into 2016 will be its international sales. International sales currently account for greater than 40% of Raytheon’s backlog, including a $2 billion dollar order from Saudi Arabia this year for a defense missiles system. Raytheon’s $33.5 billion dollar backlog, of which $24.4 billion is fully funded, grew slightly (by $300 million) in Q3, and provides moderate revenue visibility until 2018. Geopolitics could make congressional approval for future international agreements tricky to navigate, and the low price of oil could cause some Middle Eastern countries to cut their budgets, which would have a significant effect on Raytheon’s international order book going forward. Plotted below are historical sales and EPS, along with 2016 estimates.

A second driver of Raytheon’s performance going into 2016 will be its international sales. International sales currently account for greater than 40% of Raytheon’s backlog, including a $2 billion dollar order from Saudi Arabia this year for a defense missiles system. Raytheon’s $33.5 billion dollar backlog, of which $24.4 billion is fully funded, grew slightly (by $300 million) in Q3, and provides moderate revenue visibility until 2018. Geopolitics could make congressional approval for future international agreements tricky to navigate, and the low price of oil could cause some Middle Eastern countries to cut their budgets, which would have a significant effect on Raytheon’s international order book going forward. Plotted below are historical sales and EPS, along with 2016 estimates.
raytheon eps/sales

Northrop Grumman

Northrop Grumman won big in 2015, beating out both Boeing (which I recently wrote about) and Lockheed Martin in the bid to develop the Air Force’s next Long Range Bomber, a deal which could be worth upwards of $80 billion for 100 planes over the life of the contract. Naturally, Lockheed and Boeing are both formally protesting the awarding of the contract to Northrop, with a decision coming in February of 2016. If the ruling is upheld next year, Northrop will have a massive catalyst for revenue well into the next decade. If Northrop loses out on the contract, the firm will be dead in the water for 2016 growth prospects. Northrop ‘ ‘s backlog of $35 billion, $21 billion of which is fully funded, could soften the blow of any revision to the long range bomber contract, at least in the short term. Historical and analyst projected EPS and sales are plotted in the chart below:
northrop grumman eps/sales

Conclusion:

Lockheed Martin has the best revenue visibility of the bunch, with the F-35 program firmly entrenched in the U.S military’s future inventory plans, and is certainly the safest option amongst the three firms. LMT could potentially benefit from any revision to the US long range bomber contract, and should see strong revenue growth from their newest acquisition of Sikorsky. Raytheon should continue to perform steadily going into 2016, but is exposed the most of the three firms to international sales, which could either be a huge advantage or drawback in 2016. RTN’s sales uncertainty lends them the greatest opportunity to surprise investors next year. The early-2016 decision on Northrop Grumman’s long range bomber contract will be the deciding factor as to whether or not NOC appreciates or depreciates in price. Overall, Lockheed has the strongest revenue visibility of the three and is the most attractive option for investors looking for a steady return, while NOC and RTN have much greater potential to overperform or underperform.





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