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3 Top Defense Stocks For The 21st Century

Thursday, September 12, 2013 - 1:00pm

"The 20th century was the era of manned aircraft; the 21st century is the era of unmanned aircraft." -- U.S. Coast Guard Capt. Christopher Martino.

Flickr/Don DeBold
A Predator drone at the Smithsonian Institute.

Political opinions aside, there's no doubt drones are big business. You may embrace the new technology, or you may fear it is simply the next step toward an Orwellian "Big Brother" society.

But either way, one thing is certain: There is a lot of money to be made in this new technology and in national security as a whole.

After all, who makes for a better customer than the government? The government doesn't just collect money, it prints money.

Let's start with some numbers:

30,000: The number of drones estimated to be flying in U.S. airspace by 2020.

$4.5 million to $11 million: The average cost of an MQ-1 Predator drone.

65,000 to 70,000: The number of Air Force personnel currently employed to process drone data.

$82 billion: The estimated value of the drone industry by 2025.

In StreetAuthority's special new report, "The 11 Most Shocking Investment Predictions of 2014," you can learn about a promising small-cap stock in this sector that has been flying under the radar.

As tensions in the Middle East flare up yet again, it's a good time to look at opportunities in the aerospace and defense industries.

As you probably know, the U.S. spends far more than any other country on national defense. In fact, in 2011, the U.S. spent more on its military than the next 13 nations combined. The U.S. defense budget has soared 154% from 2001, to $729 billion in 2012.

There are concerns within the industry that government sequestration and austerity measures will cut spending. But the fact remains that defense spending on a large scale will almost certainly continue for decades to come.

On average, the sector is not cheap at this time. Many companies are currently trading at high valuations. Remember that buying high adds risk to the trade. The chances that stock prices will fall rather than rise increases dramatically when share prices get into the "frothy" zone.

For example, the world's largest defense contractor, Lockheed Martin (NYSE: LMT), is a great stock I would be happy to add to my portfolio. But not at 57 times book value, which is where the stock is trading.

Let's take a look at three stocks in the aerospace and defense sector that look more attractive at today's prices.

General Dynamics (NYSE: GD)
General Dynamics is currently trading around $86 per share, which is close to its 52-week high of $87.85. Yet earnings support this valuation, and the company's forward price-to-earnings (P/E) ratio is only 11, compared with an industry average of 18. The current price to book value is 2.5. The company also carries very little debt, with a debt-to-equity ratio of 0.3.

General Dynamics generates huge revenue through its contracts with the U.S. government. Its marine systems division owns three of the six submarine shipyards in the U.S. Long-term contracts with the U.S. government are estimated to be worth $78 billion for attack submarines and $140 billion for ballistic missile submarines.

The company has also had a lot of success manufacturing private jets. It boasts a 30% market share for large business jets, and this market keeps growing. In 2009, General Dynamics sold 94 jets. Last year, it sold 121.

In this year's second quarter, the company repurchased 6.6 million shares, which yield a 2.5 % dividend.

Northrop Grumman (NYSE: NOC)
Northrop Grumman is currently trading at a forward P/E ratio of 11 and a price-to-book (P/B) ratio of 2.3, despite a 38% run-up in prices so far this year.

The company generated $2.3 billion in free cash flow last year. While sales have not been as robust this year, the company's focus on especially profitable defense sectors should allow operating margins to remain around 12%.

Northrop specializes in the production of manned and unmanned aircraft, which includes radar, navigation, and targeting systems for the U.S. military's top fighter planes.

In 2012, 11% of Northrop's sales came from unmanned aerial vehicles (UAVs). UAVs have applications that extend far beyond military use, such as land surveying and helping catch drug boats along the coastline.

Northrop sports a yield of 2.5% and has increased its dividend each year since 2008.

Raytheon (NYSE: RTN)
Raytheon is currently trading at a slightly higher cost, with a P/E ratio of 12 and a P/B ratio of 3. With a yield of 2.7%, the company has an impressive history of raising dividends over the past five years. During the same period, it has reduced its outstanding share count by almost 100 million shares since 2008, to 329 million.

Raytheon's primary strength lies in its international sales. Customers include the United Arab Emirates, Saudi Arabia, Taiwan, Turkey, Oman, Kuwait and India. Overseas sales, which make up about a quarter of total revenue, should help the company lock in profits should domestic spending continue to decline.

The company's proven and successful Patriot missile defense system is a highly coveted asset around the world, and the company operates under a duopoly with Lockheed Martin in this system's production and implementation.

Raytheon CEO William Swanson has been with the company since 1972, and under his leadership management has been committed to returning 50% of free cash flow to investors over the long term.

Risks to Consider: The biggest headwind in this sector is the threat of reduced U.S. government defense spending. Expenditures can be delayed, reduced or cut during annual congressional budget allocations.

Action to Take --> Along with death and taxes, armed conflict has historically been a fact of life. Demand for defense products and services isn't going anywhere. Should short-term U.S. defense spending decline, it's only a matter of time before a foreign or domestic event causes Congress to increase spending again.

For long-term investors interested in this sector, all three stocks deserve a closer look. I find Northrop particularly attractive based on its 11% share of the drone market, which is currently in the early stages of explosive growth. Under U.S. law, companies that manufacture drones are allowed to sell them to foreign allies, creating enormous opportunities to profit from this new technology.

P.S. -- The three stocks I mentioned above are suitable for conservative investors, but we're really excited about a small-cap play on the "age of the drone" that Andy Obermueller has identified in his special new report, "The 11 Most Shocking Investment Predictions of 2014." You can learn about this and the rest of his exciting investment predictions by clicking here.

Chad Tracy does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.