Investing

RBC Picks 3 Defense Contractor Stocks as Top Performers

Paul Ausick

Published: August 30, 2022 12:41 pm

Last Updated: August 30, 2022 12:44 pm

The U.S. national defense budget for fiscal year 2022 totaled $777.7 billion and expires at the end of September. President Joe Biden has submitted a fiscal 2023 Pentagon budget totaling $773 billion and a total national defense budget of $813 billion. The House passed its version of the National Defense Authorization Act (NDAA) in July, appropriating $838 billion for the nation’s defense needs. The Senate Armed Services Committee in June approved a proposed budget of $817 billion, but the full Senate has yet to vote on the NDAA.

The increase to 2022 spending levels reflects so-called unfunded Pentagon priorities, inflation, replenishing weapons stockpiles reduced by shipments of arms to Ukraine, and full funding for the Ukraine Security Assistance Initiative.

Virtually no one expects the NDAA to be passed by Congress and signed by the president by the October 1 start date of the 2023 fiscal year. But that does not mean that all’s quiet on the defense front.

On Monday, analysts at RBC Capital Markets initiated coverage of five top defense contractors, identifying three as top performers in the sector. The five firms added to RBC’s coverage are General Dynamics Corp. (NYSE: GD), L3Harris Technologies Inc. (NYSE: LHX), Leidos Holdings Inc. (NYSE: LDOS), Lockheed Martin Corp. (NYSE: LMT) and Northrop Grumman Corp. (NYSE: NOC).

One point Herbert makes for these five prime defense contractors is their shareholder-friendly capital allocation strategy.

RBC analyst Ken Herbert initiated coverage of General Dynamics with an Outperform rating and a price target of $275. At a recent trading price of around $232.70, the implied upside on the stock is 19.5%. The average price target of 17 analysts is $259.33. The stock’s 52-week trading range is $188.64 to $254.99. The total shareholder return for the past year was 19.3%.

Herbert notes GD’s forecast for Gulfstream business jet deliveries rising from 123 in 2022 to 148 next year and 170 in 2024. That implies a $2 billion revenue increase in 2023 and a $1.6 billion increase in 2024. The company’s own outlook for a 9% increase in IT revenue is shakier Herbert believes. U.S. support for Ukraine has juiced GD’s combat division, and RBC expects a low-single-digit revenue increase next year and a sustained mid-single-digit increase in the company’s marine division.

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L3Harris gets an Outperform rating and a price target of $285 from RBC. Based on a share price of around $232.50, the upside potential to RBC’s target is 22.6%. The average price target of 18 analysts is $279.63. The stock’s 52-week trading range is $200.71 to $279.91. The company’s total shareholder return for the past year was 1.6%.

In his analysis, Herbert wrote that he believes the U.S. defense budget supports approximately 6% top-line growth for L3Harris, better than for any other prime defense contractor. Sales in the company’s communications business dropped about 12.5% in the first half of this year, but second-half sales are expected to improve by around 10%. L3Harris is RBC’s “highest conviction defense prime [contractor going] into 2023 as we expect top-line outperformance off a higher margin base [to] be a positive catalyst.”

Herbert has initiated coverage of Northrop Grumman with an Outperform rating and a price target of $550. Shares currently trade at around $481.70, implying an upside potential of 14.2%. The average price target of 17 analysts is $494.60, and the stock’s 52-week range is $344.89 to $497.20. Northrop’s total shareholder return for the past year was 33.4%.

Northrop is “best positioned” of the prime defense contractors to benefit from the recapitalization of U.S. nuclear forces. Total federal spending on nuclear forces is expected to rise by about 6% this year to 8.5% in 2030. The company also has a strong position in the space market, which grew by around 20% in each of the past two years. Herbert expects a compound annual growth rate of around 10% for the space division through 2024.

RBC has initiated coverage on Leidos with a Sector Perform rating and a price target of $106. The stock trades at around $96.10, implying an upside potential of 10.3%. The average price target of 14 analysts is $118.58, and the stock’s 52-week trading range is $81.07 to $111.12. Total shareholder return for the past 12 months is negative 0.5%.

Leidos is the leading government service provider and is looking to transition to a solutions provider with a focus on defense systems. That is both good news and bad for investors. Margins are higher for solutions, but that could limit near-term upside as the company invests more in solutions and less in services. Recent contract wins for 2023 and 2024 will provide upside in the longer term but also could weigh on near-term profitability.

RBC initiated its coverage on Lockheed Martin with a Sector Perform rating and a price target of $460. The stock trades at around $428.70, implying an upside potential of 7.3%. The average price target of 18 analysts is $463.06, and the stock’s 52-week range is $324.23 to $479.99. Total shareholder return for the past year was 21.8%.

Lockheed is the world’s largest defense contractor and is expected to benefit from the larger U.S. defense budget as well as rising international defense spending. The company (and Herbert) believe that Lockheed needs new contract wins to boost its top-line results. Revenue is expected to grow by about 2% in 2023 and 3% in 2024, after a disappointing 2022. New defense programs that Lockheed is expected to compete hard for are next-generation air dominance (NGAD), future vertical lift (FVL) and next-generation interceptor (NGI).