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."
Lockheed Martin is a security and aerospace company. The company has four segments: Aeronautics, which is engaged in the research, design, development, manufacture, integration, sustainment, support and upgrade of military aircraft; Missiles and Fire Control, which provides air and missile defense systems, logistics, fire control systems, and mission operations support; Rotary and Mission Systems, which provides design, manufacture, service and support for military and commercial helicopters, radar systems, and simulation and training services; Space, which researches, designs, develops, engineers and produces satellites, space transportation systems, and strategic, strike, and defensive systems.
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