There is some very good news for defense contractors.
The Department of Defense recently released its fiscal year 2020 budget, and spending is expected to hit $718 billion, about 6% higher than last year.
The increased spending supports sales growth targets for sector, and Wall Street has taken notice. Analysts like the entire sector. About 65% of the ratings on defense companies, such as Lockheed Martin (ticker: LMT), are “buys.” That is about 10 percentage points higher than the average for stocks in the Dow Jones Industrial Index.
The message is clear: buy defense. In particular, Lockheed, Raytheon (RTN), and Northrop Grumman (NOC) are three large contractors with strong support from the Street.
The major U.S. defense contractors generate over $250 billion in sales annually and have a market value exceeding $400 billion. What’s more, the business has been improving since the Trump administration ended budget sequestration that limited military spending growth from 2014 to 2017.
Faster growth supports higher valuation multiples. The defense components of the S&P 500 trade for about 16.7 times estimated 2019 earnings—in line with history and a slight premium to the Dow stocks that trade for 15.6 times estimated 2019 earnings.
That 7% premium appears deserved, because analysts expect defense earning to grow about 10% on average each year for the next two years, about 4 percentage points better than the Dow.
Baird analyst Peter Arment believes the budget number is a win and wrote “the defense recapitalization theme is well intact,” meaning the government is moving to replace old equipment.
Arment notes the budget includes $11.5 billion for 78 Lockheed Martin F-35 Lightning II jets. New submarines are getting $12.4 billion too. The Virginia- and Columbia-class subs are made by BWX Technologies (BWXT) and General Dynamics (GD). The government will also spend $3 billion on Northrop’s new stealth bomber the B-21.
SunTrust analyst Michael Ciarmoli added, “Next-generation technologies and capabilities [are] getting some attention.” Hypersonic weapons will receive $2.6 billion. Space technologies will receive $14.1 billion and cyber defense gets $9.6 billion. Weapons and cyber systems supports Raytheon sales.
Defense stocks fell in December, like everything else, and have rallied to start 2019, jumping 17%. That leaves the sector off about 9% from its 52-week high. With better spending from its number-one customer—the U.S. government—the sector’s stocks should be able to hit new highs this year. That is welcome news for investors who, according to analysts, have many different ways to win.