Defense Contractors Stealthy Gains

While banks and healthcare have populist political footballs, defense contractors, which used to get tied to the whipping post, are flying under the radar to record profitability. Shares of firms such as Lockheed-Martin (LMT), Raytheon (RTN) and Northrop Grumman (NOC) have stealthily climbed to 52-week highs, having gained some 10%-20% just this year alone. These stocks should continue to climb as rising global geopolitical tensions and violent conflicts leads to an increase in military spending, especially in emerging markets.

Granted, the above is not a feel-good investment story, which may be the reason these stocks, despite being among the best performers, do not see their tickers tweeted or CEOs profiled in financial media. But is it a cold fact of the current global environment – one from which investors can profit. I suppose the title of this could have been “War, What is Good For?”

At least that’s one of the conclusions to be made from the recent report from the Stockholm International Peace Research Institute (SIPRI), which shows after years of decreases, defense spending is back on the upswing. And not just in the U.S., which has always and remains far and away the biggest spender, but around across the world, even in places where previously there has barely been military or defense budgets.

Globally, the nations of the world spent $1.7 trillion on defense last year. That was up 1.2% from 2014 levels, and it was the first increase in global military spending since 2011. Spending in the U.S. actually declined between 2014 and 2015, but it has already begun rising as “fiscal” 2016 – up about 3.6% from fiscal 2015 levels to an expected $580.3 billion.

Meanwhile, the Pentagon’s latest five-year budget overview envisions our “base” defense budget continuing to grow. Base spending levels are projected to rise about 6% in total over the next five years, hitting $581.4 billion, this does not “overseas contingency operations” (OCO), spending that usually averages $60 billion or so a year, in 2021. And so it seems the U.S. is destined to remain the world’s largest military in term of size and budget for the foreseeable future.

Defense budget overseas image 5.10.16

Global Players Catching Up

Still lagging the U.S. in total spending but racing to catch up, are the No. 2 and No. 3 defense spenders, China and Russia. Respectively, these two countries spent 7.5% and 7.4% more in 2015 than they had in 2014. That’s especially surprising in Russia’s case, where depressed oil prices have put a pinch on the federal budget – but it’s still seeing an increase across the old USSR region.

In Central Europe alone spending was up 13 per cent. There were particularly large increases in countries bordering Russia and Ukraine – namely Estonia, Latvia, Lithuania, Poland, Romania and Slovakia – which are those most concerned about Russia’s intentions following the crisis in Ukraine. In contrast, Western European expenditure was down 1.3 per cent but this was the lowest rate.

Military spending in Asia and Oceania rose by 5.4 per cent in 2015 and was heavily influenced by China. Heightening tensions between China and various countries in the region contributed to substantial increases in expenditure by Indonesia, the Philippines and Viet Nam, and triggered the start of a reversal of the long-term downward trend in Japan’s military spending.

Defense spending worldwide changes image 5.10.16

As this reality plays out, U.S. defense firms are increasingly looking overseas to grow their revenue. Raytheon, General Dynamics (GD), and L-3 Communications (LLL) in particular have been working to diversify their revenue streams away from the U.S. and toward faster-growing defense markets in Southeast Asia and the Middle East. Raytheon now gets nearly one dollar in three from international sales. General Dynamics gets more than one dollar in four from abroad. L-3 Communications has more than doubled the amount of money it makes from sales to Asia and the Pacific over the past year.

Recent earnings reports from LLL, RTN and NOC all beat estimates and the companies all provided positive guidance, but LMT’s report was especially impressive. It not only raised its top line full-year revenue outlook to $49.6B-$51.1B from $49.5B-$51B and increased its bottom line EPS guidance to $11.50-$11.80 from a January forecast of $11.45-$11.75, it also lifted its operating profit margin by 30 basis points.

This revenue growth is all the more impressive considering the fact Lockheed Martin spent tens of millions of dollars reducing its aeronautics and information systems & global solutions divisions. Lockheed Martin will likely continue to perform well given its increasingly tight grip on the defense industry and heavy involvement in promising emerging markets. With instability plaguing many regions of the world, demand for Lockheed Martin’s defense products should remain robust.

Lockheed Martin’s international business should be a significant growth driver moving forward as the company expects international growth to ramp up to about 25% in the near-term future. With Lockheed Martin’s Sikorsky integration moving along smoothly and the company’s F-35 line gaining traction, Lockheed Martin is set to accomplish its growth roadmap. In fact, the Sikorsky acquisition helped boost Lockheed Martin’s mission systems & training revenue by approximately $1 billion this year.

Keeping the pipeline full are recent contract wins, including Lockheed Martin being awarded the $1.27 billion contract for its F-35 Lightning II fighter jets, and a joint deal with Raytheon was awarded a combined $649.7 million modification contract for Paveway II laser-guided bombs.

Lockheed Martin still has more room to grow at its current market capitalization of $70 billion, as the company, after shrinking its IT department, is not only focusing on its core business and also moving into new areas such as energy storage via lithium batteries.

My one hesitation at this point is the chart looks a bit overbought and I don’t want to chase it here. I’d wait for pullback towards the $235 level to look for an entry point.

LMT 061016

In an unsafe world defense contractors can provide your portfolio with needed protection.

— Steve Smith

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About the Author: Steve Smith