Military conflict is in the air because of chemical weapons
use in the Syrian civil war. The geopolitical landscape in the
Middle East is tense beyond Syria given social turmoil in Egypt,
social unrest in Libya, and Iran's nuclear development.
Geopolitical instability may keep a focus on defense stocks, as
countries look to beef up their defense capabilities in a hostile
Investors may see the defense sector as an area of safety
during a period of geopolitical instability; however, budget
pressures in the U.S. and sequester are headwinds to defense
sector. Further, popular opinion in the U.S. does not seem
to support a new military conflict in the Middle East. It would
likely take a further escalate of events and more direct impact
on U.S. or European national interests to generate a sustained
military campaign, and clearly turn the downtrend in defense
spending. During his speech on Friday, Secretary of State
Kerry sounded tough on the need to show military response to
chemical weapons use in Syria, but finished by downplaying the
idea of sustained U.S. involvement or the use of ground
The graphic below displays the trend in U.S. government
spending on defense. Notice that spending has been flat to
lower since 2010 and has recently shown contracting growth.
The next graphic highlights the trend in unfilled defense
orders against the average price of major defense names -
). Notice that the stocks have rallied sharply in recent
months, while unfilled orders have moved sideways. The
relationship is loose and transient. The correlation is
0.69. The market may be sensing upward pressure on defense
spending in the future.
The defense sector is showing mixed valuation. Let's
look at valuation based on price to forward 12 month earnings and
the PEG ratio. Going back to the middle of 1998, LMT, GD,
RTN, and LLL are all trading with a 12 month Forward PE ratio
which is below their median value, but most are comfortably above
the their low values. NOC is trading a shade above.
The history on
Huntington Ingalls Industries
) is shorter going back to April 2011, but the forward 12 month
PE is elevated compared to this time period and high compared to
the group. On a relative basis, LLL looks the cheapest with
the largest discount to its median value. NOC appears more
expensive compared to LMT, GD, RTN, and LLL.
In contrast to the forward 12 month PE ratio, the sector leans
richly priced basis the PEG ratio. LLL has the highest PEG ratio
compared to its median value and among its peers. HII has
the lowest PEG ratio among the group and is trading near the
median of its short history.
The divergence in valuation is probably related to the slower
growth outlook for the industry due to budget cuts and what has
been a reduction in defense spending. The low forward PE
ratios reflect the weaker outlook for profit growth given the
trend in defense spending. The PEG ratio may better reflect
the valuation because it is using the growth rate in the
calculation - price to earnings to growth rate in earnings.
Earnings Revision Trend:
Despite the poor trend in U.S. defense spending and flat trend
in backlog, earnings estimates for the sector have generally been
moving higher over the past thirty days. The table displays
the Zacks Rank, number of estimate revisions, and change in the
Zacks Consensus Earnings per Share Consensus Estimate for this
year (2013) and next year (2014) over the past 30 days.
The table shows four Zacks Rank #2 (Buy) and two Zacks Rank #3
HII has shown the strongest number of upward earnings estimate
revisions to downward earnings estimates for this year.
Looking to next year, RTN has seen the strongest number of upward
In terms of actual EPS changes, it looks like HII has the
strong upward revision to the consensus for both years.
The general upward earnings revision trend is interesting, as
all the companies but HII are expected to see sales contract in
2014. HII's sales growth is expected to be the strongest,
but will basically be flat with 2013. NOC and LLL are
expected to see the largest drop in 2014 sales relative to 2013
sales off 4.6% and 4.1% respectively.
Defense stocks have traded firm to the market in recent weeks,
and seem to be getting some support from the geopolitical
landscape. Examining the tables, it looks like HII has the
strongest upward momentum to earnings estimate revisions and is
priced at an attractive PEG ratio below 1.0 - it selling for less
than its growth rate.
The company designs, builds, and maintains nuclear and
non-nuclear ships for the Navy and Coast Guard, and provides
after-market services for ships. It seems like any U.S.
intervention in Middle East is likely to be led from the air and
supported by the Navy. Furthermore, the uncertainty over
potential closure of the Suez Canal in the wake of Egyptian
unrest could call for a strong U.S. Navy presence in the
region. HII could benefit and/or be supported by
geopolitical developments Middle East.
LMT, RTN, and GD could get some help from the use of missiles
and air defense systems. RTN may have relatively cheap valuation
to GD and LMT. It is a Zacks Rank #2 (Buy).
Hopefully, geopolitical stability will pass, but defense names
are likely to remain on the market's radar screen for the near
GENL DYNAMICS (GD): Free Stock Analysis
HUNTINGTON INGL (HII): Free Stock Analysis
LOCKHEED MARTIN (LMT): Free Stock Analysis
NORTHROP GRUMMN (NOC): Free Stock Analysis
RAYTHEON CO (RTN): Free Stock Analysis Report
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