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 geopolitical environment.
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 troops.
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 – Lockheed Martin (LMT - Analyst Report), Raytheon (RTN - Analyst Report), General Dynamics (GD - Analyst Report), Northrop Grumman (NOC - Analyst Report). 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 (HII - Analyst Report) 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 (Hold) companies.
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 revisions.
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 future.