Morningstar | Investors are Hungover on Defense Stocks but the Spending Party Hasn't Even Started Yet
Over the past several months, defense stocks have stalled, underperforming the S&P 500, but we believe that industry growth rates will accelerate through 2019 as recent increases in the Department of Defense budget translate into outlays to the industry. Our regression analysis tying industry revenue growth to U.S. defense outlays predicts double-digit revenue growth for some industry names by second-quarter 2019.In addition, we think the midterm elections slated for early November 2018 could provide an entry point into defense stocks, as uncertainty rises ahead of elections. Over the longer term, we see defense budget growth stalling out in 2020 and beyond due to persistent budget deficits and rising national debt. The 2020 Presidential election also represents a potential risk to defense spending. We continue to appreciate the sturdy moats in the U.S. defense industry and we note nearly all the defense names we cover possess wide moats. Stricter Department of Defense regulation of contract pricing, particularly in the wake of tax reform represents the only threat to moats in our view.
Although it's tough to find cheap stocks in the defense sector, we like General Dynamics, trading at a price/fair value ratio around 0.88. The company isn't a defense pure play because of its business jet unit, but with the CSRA acquisition, defense and government-related activities now account for roughly 75% of consolidated revenue. For investors preferring a defense pure play, we'd point them to Raytheon or Northrop Grumman, with both trading at discounts to our fair value estimates.
We outline our views on the U.S. defense budget and how increases under the Trump administration will drive industry revenue and earnings higher in our recently published Select piece titled "Investors are Hungover on Defense Stocks but the Spending Party Hasn't Even Started Yet."
General Dynamics is an aerospace and defense company. The company has five operating segments: Aerospace, which provides a family of Gulfstream aircraft and services for business aircraft produced by Gulfstream and other original equipment manufacturers; Combat Systems, which provides combat vehicles, weapons systems and munitions; Information Technology, which provides information technology (IT) services, IT infrastructure modernization and professional services; Mission Systems, which provides mission-critical products and systems; and Marine Systems, which designs and builds nuclear-powered submarines, surface combatants, and auxiliary and combat-logistics ships.
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