The Cold War is long over. The peace dividend has been spent. Thirty-six years after the fall of the Berlin Wall, however, the world seems more dangerous than ever. There are conflicts in the Middle East, border wars in Southeast Asia, artificial islands popping up in the South China Sea and of course… the largest land war in Europe since World War II continues to unfold.
I think it might be a good time to invest in some defense stocks?
Well, me too – and apparently, a lot of people too! For months, I have been warning that defense stocks are becoming more and more expensive as investors look to the global trend of growing military budgets. The good news is that while defense stocks as a whole are getting expensive, there are still some good deals to be found in the sector.
If you have $500 to invest, here are two that come close to my self-defined standard for what constitutes a good price for a defense stock: Textron(NYSE:TXT) And Huntington Ingalls(NYSE:HII).
Image source: Getty Images.
Textron may be less well-known than some of the biggest defense contractors, but you’re definitely familiar with some of its brands. The company’s largest division, Textron Aviation, produces Cessna and Beechcraft aircraft, for civil and military customers. Likewise with Bell Helicopter, the company’s second division in terms of revenue. In partnership with BoeingBell also builds the V-22 Osprey tilt-rotor aircraft for the United States Marine Corps.
On the ground, Textron Systems builds M1117 armored vehicles for the army, LCAC 1000 hovercraft for the navy, as well as the RIPSAW M5 robotic tank (developed by Howe & Howe, now a subsidiary of Textron).
Valued at $15.8 billion in market capitalization, Textron stock sells for a modest 19 times current earnings. Although a bit more expensive when valued on a free cash flow basis (22.7 times FCF), the stock’s price-to-sales ratio is very close to my preferred single valuation for US defense stocks – just under 1.1.
Of all the defense stocks I watch, Textron is one of the two cheapest by this metric.
Huntington Ingalls is slightly cheaper than Textron. And for those who don’t know, Huntington is the former military shipbuilding branch of Northrop Grummanwhich was spun off from its parent defense company in 2011. The stock price has increased 8-fold since its split, although its sales have barely doubled – a good object lesson in the value of patience for Northrop and for investors.
Huntington Ingalls is one of the leading shipbuilders in the US Navy today. It specializes in building nuclear-powered aircraft carriers and nuclear submarines, while also building an assortment of amphibious assault ships, destroyers and cutters for the U.S. Coast Guard. As long as the South China Sea remains the focus of U.S. defense policy, the company can expect a steady stream of revenue as the U.S. Navy attempts to keep pace with the ever-expanding People’s Liberation Army (PLA) Navy, already the world’s largest navy.
With a market cap of just over $13.2 billion and annual revenue of $12 billion, Huntington Ingalls stock (like Textron) costs about 1.1 times the valuation of annual sales. But it costs more and for good reason.
Until the end of last week, you see, Huntington Ingalls was trading significantly below Textron on valuation. But on Friday, the US Navy announced that it had chosen Huntington to design and build a new “small surface combatant” to replace the fleet of ships built by Fincantieri. Constellation-class frigates that the Navy has just canceled. The Navy chose the design established by Huntington for the National Security Coast Guard to form the basis of this new frigate – and the stock of Huntington Ingalls quickly increased by more than 4 percent.
It is not clear how much this new contract will be worth to Huntington Ingalls. But it should be noted that the Constellation The program originally aimed to build at least 20, and potentially three times as many, frigates for the Navy. Now, Fincantieri will only build two Constellations, meaning there is plenty of room for the Navy to accept new frigates from Huntington, and much more potential for revenue growth at Huntington.
Both of these stocks are cheap enough to be a no-brainer for patient defense investors. But of both stocks, if I had to invest $500 in just one, I would have to say I prefer Huntington Ingalls.
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Rich Smith has no position in any of the stocks mentioned. The Motley Fool holds positions at and recommends Boeing. The Motley Fool recommends Textron. The Mad Motley has a disclosure policy.
