Last week, I discussed why aerospace and defense stocks could be among the market's biggest winners over the next two years.
Essentially, Congress and President Obama have unfrozen the defense budget from spending caps, agreeing to spend $37 billion more than expected over the next two fiscal years.
The bottom line: instead of a continuation of steep spending cuts in defense, the budget will actually increase for the first time in six years. And no one is breathing a bigger sigh of relief than defense contractors, many of whose revenues and earnings depend substantially on Department of Defense procurement. While the budget agreement only covered the next two years, analysts expect that regardless of who is elected president next November, defense spending will continue to rise in the coming years.
Boeing (NYSE: BA ) is the world's largest aerospace company and one of the largest defense contractors in the world. With Airbus ( EADSY ), it is one of only two major makers of commercial wide-body aircraft. Its business is split among commercial aircraft, defense and space -- all of them growth sectors in which Boeing is a technological leader and long-established player, with customers in 150 countries.
In addition to commercial and military aircraft, Boeing produces satellites, weapons, electronic and defense systems, launch systems, advanced information and communication systems and logistics and training products and services.
Boeing has about a 50% global market share for commercial aircraft, with more than 10,000 in service worldwide, and a 90% share in air freight. In addition to the established 737, 747, 767 and 777 planes, Boeing is launching the 787-10 Dreamliner and the 777X. Its military aircraft include the KC-46 aerial refueling aircraft, the AH-64 Apache helicopter, the F/A-18 fighter, EA-18G electronic attack aircraft, the P-8 anti-submarine/anti-surface warfare plane and the Phantom Eye unmanned aircraft system.
Boeing's product cycle for commercial aircraft is based on airlines transitioning to new planes, which are more profitable but cost an enormous amount to develop. Some analysts are concerned that 777 orders will tail off in the coming years as Boeing moves to introduce the new 777X in 2020. But the company has continued to enjoy solid demand from emerging markets and the Middle East, as well as U.S.-based airlines, which are in better financial shape than they've been in years. Though aging, the single-aisle 737 fleet remains a strong contributor to cash flow, and the new 737 model will be 20% more fuel-efficient. Meanwhile, military orders have been sustained by growing demand for unmanned aircraft and the massive KC-46 program to replace the Air Force's refueling tankers.
Boeing's earnings are rising strongly -- up 18% in the third quarter -- and it generates strong cash flow and has reasonable debt. Earlier this month, the company announced it would raise its quarterly dividend to $1.09 from 91 cents; on that basis, the stock yields a healthy 3.1% now. Boeing also regularly buys back its own shares, to the tune of around $6 billion a year, boosting per-share values over time.
At recent prices, Boeing shares trade at a reasonable 15.1 times analysts' consensus estimate for 2016 earnings per share.
L-3 Communications (NYSE: LLL ) is a leading maker of communications and electronic systems used in a range of military and commercial applications. It is best known for its communications systems, which integrate digital audio, video and data in almost every mission-critical aerospace platform used by the United States and many other militaries. Its highly innovative products include sophisticated avionics and display technologies; high-quality simulators and trainers; laser-based weapons; sensors and power systems.
The company is well-positioned to enjoy rising revenue from the growing need for high-tech information technology and communications technologies, both for military and homeland security use. The U.S. Department of Defense accounts for about two-thirds of revenue, making L-3 one of the happiest companies to read news of the bipartisan budget agreement boosting Pentagon spending. About a quarter of revenue comes from overseas.
The company is taking steps to fine-tune its product portfolio to focus on fast-growing areas and high-margin products and services; as part of the move, it recently announced it would sell its government consulting/services business to focus on high-tech products. Like Boeing, L-3 generates strong cash flows and regularly buys back its own shares.
At recent levels, L-3 shares yield 2.2% and trade at 17.6 times analysts' consensus estimate for 2016 earnings per share. While not a screaming bargain, this is an attractive entry point for this innovative leader well-positioned for growth in the coming years.
Risks To Consider: All of these stocks are subject to risk from negative news involving a key product or procurement contract. A faster-than-expected increase in interest rates would hurt Boeing's sales, as it increases borrowing costs for its customers.
Action To Take: Buy Boeing below $145 and L-3 Communications below $120.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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