Aerospace / Defense Contractors Look Attractive

By: Steve Rubis

Aerospace and Defense Contractors have experienced a boom in business. Once President George W. Bush declared war on Iraq in March of 2003, defense spending accelerated at a pace not seen since the Cold War. Many of the major players still exist: Lockheed Martin, Northrop Grumman, General Dynamics, Raytheon and Boeing. These companies continue to be successful because they have adapted to the changing landscape of defense spending. During the Cold War, budgets were allocated to planes and missiles; today, the traditional defense contractor is a jack of all trades. Significant revenues come from Homeland Security initiatives as well as Government IT.

Outlook: The major players will continue to ink substantial contracts driving earnings acceleration. Investors must be aware of the 2008 election as a major catalyst for change.

1.) Presidential Election of 2008: If the Democrats take the White House, or Congress significantly changes military spending, leaner profits will come to characterize the industry.
2.) Substantial Consolidation: certainly, the biggest firms will remain intact, however. These firms will seek to gobble up the smaller niche entities within the Defense Sector. Niche firms will allow the larger corporations to diversify product offerings and hedge expected holes in revenue streams.
3.) Private Equity Firms: the unprecedented amounts of capital available for investment will affect aerospace / defense contractors. Some analysts are expecting a majority of firms in the industry trading for less than $1B will be taken private.
4.) Talent Retention: these firms will continue to be hindered by the strict and rigid compensation structures required to meet government audit standards. As long as more attractive compensation packages are not available, the top talent at these firms will be enticed by competitors and Wall St.
5.) Generational Gaps: aerospace and defense firms are facing a talent crisis as their aging employee base continues to get older. These companies need to find more efficient ways of attracting and retaining young talent. They will need to overcome point number four in order to achieve this goal.
6.) Operation Iraqi Freedom: if Democrats are able to effect changes in military spending, this sector will be hit hard. The war and so called occupation have helped contractors to generate greater profits.
7.) Chinese Hegemony: the growth of China as an economic and world political power will directly affect the industry. If China chooses to pursue hostile activities, the defense sector will continue to experience the current boom.
8.) War on Terror: the attacks of 9/11 moved defense to the forefront of all Americans. As the US continues to track and foil terrorist plots, Defense Contractors will reap the financial benefits.

Table 1: Aerospace / Defense – Industry Metrics


Overall, table number one shows the Aerospace / Defense Industry to be quite ho-hum. The average P/E suggests a slight premium confirming the boom scenario. Aerospace / Defense stocks are quite stable given their 1.35 beta, and have decent returns on assets and equity. Unfortunately, the capitalization rate is nothing to write home about. These businesses are capital intensive due to R&D of new military technologies. A score of 2.99 on the Altman Z indicator shows that the majority of undervalued firms in this industry are financially sound.

Table 2: Altman Z Scores for Selected Aerospace / Defense Companies


Investors will find the high scores related to the market value of equity compared to total liabilities troubling. Trouble arises because a substantial portion of the Altman Z score is derived from the lowest weighted factor. Nevertheless, each company derives a respectable score on the other indicators. This means that, with the exception of two companies, bankruptcy is not an issue.

Table 3: Aerospace / Defense Industry – Average Values


Simple review of table three suggests that the industry as a whole is undervalued by nearly 10%. This is a significant enough discount to merit further research. The following stocks offer opportunities for further research:

Undervalued:
1.) Hawk Corporation (HWK) – 39.34%
2.) DRS Technologies, Inc. (DRS) – 34.98%
3.) Kaman Corporation (KAMN) – 34.33%
4.) Northrop Grumman Corporation (NOC) – 31.82%
5.) Ducommun, Inc. (DCO) – 30.81%
6.) Esterline Technologies, Inc. (ESL) – 28.84%
7.) Triumph Group, Inc. (TGI) – 19.15%
8.) Lockheed Martin Corporation (LMT) – 18.45%
9.) General Dynamics Corporation (GD) – 14.10%

These stocks offer the possibility of material returns and are worth further research.

*Note: The author can not be held responsible for gains or losses incurred on trades based on this research. Data presented herein are for suggestive purposes only. The data and valuation calculations are as accurate as possible. The majority of data is taken from Yahoo!Finance.

**The author works for Lockheed Martin and owns LMT shares in his 401(k)plan.