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3 Defense Stocks Defying Sequestration

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Sequestration and spending cuts were expected to adversely affect the performances of the defense behemoths that explicitly provide products and services to the U.S. Department of Defense. In reality, the defense players are doing extremely well despite the fear of Damocles' sword hanging over defense budgets and big-ticket programs.

Per the sequestration legislation that came into effect from Mar 1 this year, spending on nearly every US defense budget item will be slashed by 10%. Yet the five biggest defense firms -- Northrop Grumman Corp. (NOC - Free Report) , Lockheed Martin Corp. (LMT - Free Report) , General Dynamics Corp. (GD - Free Report) , The Boeing Company (BA - Free Report) and Raytheon Company (RTN - Free Report) -- rallied 46%, 42.4%, 41.8%, 47.9% and 31.2%, respectively, over a one-year period, as of Jul 24.

The companies have been posting strong results during the ongoing earnings season, with increased expectations, share buybacks and dividends. The bullish trends may be attributed to complex military programs being awarded to these companies much before the across-the-board spending cuts came into force.

The most notable programs include Huntington Ingalls Industries, Inc.’s (HII - Free Report) building of nuclear-powered aircraft carriers at its Newport News Shipbuilding yard in Virginia, Boeing’s KC46A air tanker refuelling aircraft and Lockheed Martin’s F35 joint strike fighter. The stream of contract wins has largely left these stocks unscathed despite forebodings on the contrary.

Bet on These Top Three Players

If given to choose the top three defense stocks, we would suggest the following names: Lockheed Martin, Spirit AeroSystems Holdings Inc. (SPR - Free Report) and Boeing. While Boeing seems pricey at current levels, both Lockheed Martin and Sprint AeroSystems are undervalued right now. All three stocks sport a Zacks Rank #2 (Buy).

The world’s largest stand-alone defense contractor, Lockheed Martin, whose 82% of sales come from the U.S. government, is trading at 12.5x the estimate for 2013, a 16.5% discount to the peer group average of 15.0%. Based on its strong operational performance, analysts expect a solid long-term earnings growth rate of 6.2%.

To date, Lockheed Martin with its industry-leading F-16, F-22, and F-35 fighter jet models continues to receive funds from the DoD. It also includes an additional $8.4 billion in funding this year for the development its turbulent F-35 joint strike fighter, a program that is seven years behind schedule.

Again, headquartered in Wichita, Kansas, Spirit AeroSystems is expected to witness earnings growth of 793.0% for this year and 18.8% for 2014. The stock is moving for about 11.2x the estimate for 2013, a 8.6% discount to the peer group average of 12.3x. Its price-to-book (P/B) ratio of 1.7 suggests that the stock is still undervalued. Our views are supported by the company’s long-term expected earnings growth of 12.5%.

Meanwhile, the share price of Boeing seems to be shock resistant despite several glitches with its 787 Dreamliner. If we set apart the second quarter earnings beat, the company also raised its top-line expectation for the year. Despite reporting flat revenues at $8.2 billion at Boeing Defense, Space & Security unit owing to the sequester, operating margin expanded 40 basis points to 9.5%.

Shares of Boeing are going for about 17.2x the estimate for 2013. Though it looks a bit pricey, the investors may be willing to pay more given its solid fundamentals and its long-term expected earnings growth of more than 10%.

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