Investors may buy stocks in defense contractors because of their record of dividend payments and share repurchases for good reasons. Over the past five years, the best performing defense stock has nearly quadrupled the 78% return of the S&P 500 over that same period. Are these stocks overbought or do they still have some room to run?
The Budget Control Act of 2011 snipped about $1 trillion from defense spending over a period of 10 years. Part of the law, known as sequestration, enforced across-the-board cuts to the defense budget and, after causing a major kerfuffle in 2013, has not been triggered since as Congress has managed to keep spending under budget caps.
The budget caps have contributed to a spending cut in defense programs of about 25% between 2008 and 2015, not including the off-the-budget items paid for from the Overseas Contingency Operations (OCO) account. Analysts at Morningstar believe that defense spending has now reached a bottom and will begin to rise by around 1% to 2% a year over the next five or six years.
Because the industry has been adept at keeping its margins and return on capital high throughout the latest rough patch, the bottom line has been pretty much preserved. Increased federal defense spending means that the top line should improve and that could translate into even better margins and returns.
Analysts at JPMorgan appear to agree with essentially the rationale. The firm raised price targets on five defense firms Thursday morning, saying that what matters going forward is free cash flow. It’s not too much of a stretch for investors to read that to mean more returns in the form of dividends and share buybacks.
General Dynamics Corp. (NYSE: GD) was maintained at Outperform and the price target was raised from $157 to $172. As recently as late March, JPMorgan’s price target on the stock was $114. Based on Wednesday’s closing price of $152.29, the implied upside is 12.9%. The stock’s 52-week trading range is $121.61 to $153.80, and the consensus 12-month price target is $166.92 (likely not including the JPMorgan hike).
L-3 Communications Holdings Inc. (NYSE: LLL) was raised from Neutral to Outperform and Morgan’s price target was lifted from $158 to $182. The analysts have named L-3 as their top pick in the defense sector. At the most recent closing price of $146.78, the potential upside in the stock is 24% and the 52-week range is $101.13 to $154.50. The consensus 12-month target is $163.22.
Northrop Grumman Corp. (NYSE: NOC) was dropped from Overweight to Neutral Thursday morning, but the price target was lifted from $225 to $231. Shares closed previously at $213.10, yielding an implied gain of about 8.4%. The 12-month price target is $232.92 and the 52-week range is $158.84 to $224.12.
Raytheon Co. (NYSE: RTN) was maintained at Buy and the price target was raised from $145 to $165. At Wednesday’s closing price of $141.07, the potential upside is 17%. The 52-week range is $99.60 to $143.39.
Harris Corp. (NYSE: HRS) sports a Buy rating from the JPMorgan analysts, and the price target was lifted from $93 to $104. At Wednesday’s closing price of $91.02, the implied gain is 14.3%. The consensus 12-month target is $97.71 and the 52-week range is $70.10 to $91.99.