International passenger air traffic has grown by an average of 6% annually in the last ten years. International air traffic rose 6% in 2011, according to the International Air Transport Association and is projected to grow 5% annually over the next two decades. On the other hand, the defense industry is driven primarily by the U.S. military budget. Let's take a look at two companies in the Aerospace & Defense sector and see which one is doing better and thus stands as the best investment.
The Boeing Company (NYSE:BA) is the largest aircraft manufacturer in the world, and one of the largest aerospace and defense companies. It conducts business through three operating segments:
- The commercial airplanes segment via Boeing Commercial Airplanes (accounts for 60% of revenues and 60% of operating profits in 2012)
- The Boeing Defense, Space & Security (39%, 39%) is the world's fourth largest military contractor and is divided in three segments as well: Boeing Military Aircraft (BMA), Network and Space Systems (N&SS) and Global Services and Support (GS&S)
- Lastly, the Boeing Capital Corp. (1%,1%) that finances Boeing aircraft for airlines.
Commercial Airplanes Segment
This segment is getting better due to the increase in passenger and freight traffic. Companies will soon need to replace older airplanes with new versions. As a result, in 2011, Boeing launched the 737 MAX, a competitive offering to Airbus's A320neo (new engine option). Both aircraft are under development and are primarily re-engineered versions of current narrow body models, offering airlines greater fuel efficiency. With this innovation it is expected to strengthen its balance sheet and regain market share. Deliveries will start in 2017 and the firm claims that it will be 16% more fuel efficient than current narrow body aircraft.
Boeing Defense, Space & Security (BDS) businesses
Demand is driven by growth in the procurement and R&D sectors of the U.S. defense budget. Official Statistics shows that those sectors expanded at 8.4% and 5.5% compound annual rates, respectively. However, the history can change due to pressure resulting from high U.S. budget deficits.
In terms of valuation, the stock sells at a trailing P/E of 23.9x, trading at a premium compared to an average of 18.2x for the industry. Analysts’ expectations imply a forward P/E of 17.31. To use another metric, its price-to-book ratio of 13x indicates a discount versus the industry average of 2.45x and the price-to-sales ratio of 1.17x is above the industry average of 1.07x.
A Blue Chip Defense Contractor
Lockheed Martin Corporation (NYSE:LMT) is the world's largest military weapons maker. In 2012, the company derived 82% of its net sales from the U.S. government. Sales to foreign governments contributed 17% of net sales (17% in 2011), with 1% of net sales to commercial and other customers. The company operates in five segments: Aeronautics; Missiles & Fire Control (MFC); Mission Systems & Training (MST); Space Systems; and Information Systems & Global Solutions (IS&GS).
Key Fighter Aircraft Programs
The Aeronautics segment (31% of revenues and 30% of segment operating profits in 2012) primarily makes fighter jets and military transport planes. Production programs that are expected to generate a constant inflow include the F-35 Lightning II, the F-16 Fighting Falcon, the F-22 Raptor, the C-130J Hercules transport plane, and the C-5M Super Galaxy modernization program.
The management is returning good portions of its free cash flow ($2.7 billion during Q2) to shareholders through share repurchases and dividends. In the first half of 2013 the firm repurchased 9.6 million shares for $926 million.
Its P/E multiple on a trailing-12 month basis is 15 and the forward P/E multiple is 13.19. The current dividend yield is 3.44%, which is quite good to protect the purchasing power.
Finally, I always like to see of one of the most important financial ratios applying to stockholders, the best measure of performance for a firm's management: the return on equity.
|Company||ROE||Compared to Industry Mean (=12.8)|
It is very important to understand this metric before investing in a high-growth company.
It seems difficult to decide which of the described companies will perform better in the future. I think both of them are well positioned to take advantage of future market conditions. However, the defense sector is unpredictable due to uncertainty of the annual government budgeting, as well as election cycles. For this reason, it seems like the right time to add Boeing’s stock to your long-term portfolio (mainly for its diversified business model).
Hedge fund guru like George Soros, Louis Moore Bacon and Bill Frels added this stock to their portfolios, and I would advise fundamental investors to consider adding this stock to theirs as well.
Disclosure: Victor Selva holds no position in any stocks mentioned.