Al Root
Investors are wondering what is next for defense stocks after a swift two-day decline triggered by rising uncertainty.
Things could turn out better than feared.
Three things are weighing on investors' minds. For starters, Tuesday's nomination of Pete Hegseth as defense secretary surprised Wall Street. That was followed by a Thursday report from Reuters that indicated the coming Trump administration plans significant turnover at the Defense Department.
Topping things off is the newly created Department of Government Efficiency, headed by Tesla CEO Elon Musk and Roivant Sciences founder Vivek Ramaswamy. They are tasked with reducing wasteful government spending, and no one knows how that will affect the defense sector.
It was a lot for investors to digest in a short time. Shares of large defense contractors Lockheed Martin, General Dynamics, Northrop Grumman, and L3Harris Technologies fell 5.5% on average between Tuesday and Thursday. The iShares Aerospace & Defense ETF fell 1.9%.
Boeing is a large defense contractor, but the company's problems in commercial aerospace have already slammed that stock. Coming into Friday trading, Boeing stock was down about 47% year to date and 69% from record highs reached in March 2019.
"There is an opportunity if you accept the view that the initial chaos and turmoil driven by the Trump 2.0 administration could end up a significant positive for Defense," wrote Seaport Research Partners analyst Richard Safran in a Friday report. "Through the turmoil, we think the Trump administration is likely to implement fiscal and foreign policy changes that are substantive positives for Defense stocks."
Military spending is likely to grow in a second Trump administration, he says.
Safran isn't worried about DOGE either, recounting the story of the "$600 hammer." In the 1980s, waste in defense was epitomized by the story of the government paying $600 for a hammer costing $15 at retailers. "Reality was that $600 was the minimum legal amount that [could] be charged under Government procurement rules," he wrote.
While DOGE could target procurement rules, that wouldn't necessarily affect profit margins. It is a change to how business is done on the government side of the equation, says Safran. In other words, the hammer supplier still made $10 while the government spent $600. Procurement and red tape add up.
Citi analyst Jason Gursky quantified the potential damage from the "chaos and turmoil" Safran referred to. He wrote Friday that defense contractors' price-to-earnings ratios could fall another 18% as investors look back to how the sector performed in past eras of reduced spending.
"The period 2010 to 2013 is likely the timeframe most investors will look to given that budgets were under pressure as the wars in Iraq and Afghanistan wound down and the Budget Control Act capped spending during that era," he said.
Lockheed, Northrop, General Dynamics, and L3Harris trade for an average of 18.2 times estimated 2025 earnings. A decline of 18% implies the average could hit 14.9 times.
That is the risk, but like Safran, Gursky doesn't see a bad outcome for contractors from government efficiency efforts. "We are skeptical that DOGE will have a profound impact on defense spending given the geopolitical environment and Congressional support," he wrote.
Gursky rates Lockheed, General Dynamics, and L3Harris shares at Buy. He rates Northrop shares at Hold.
His price targets for Lockheed, GD, and L3Harris are $700, $354, and $291, respectively. His price target for Northrop is $587 a share. Lockheed stock closed at $538.99 on Thursday. Northrop, GD, and L3Harris ended the day at $500.34, $292.42, and $248.16, respectively.
Safran says Lockheed, Northrop, and L3Harris, are his "favorite names," rating all three at Buy. His price targets for the three are $670, $599, and $324, respectively.
Overall, General Dynamics and L3Harris are the most popular on Wall Street. According to FactSet, 63% of analysts covering those stocks rate them Buy. The average Buy-rating ratio for stocks in the S&P 500 is about 55%. The respective numbers for Lockheed and Northrop are 46% and 37%.
Write to Al Root at allen.root@dowjones.com
This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.
(END) Dow Jones Newswires
November 15, 2024 10:44 ET (15:44 GMT)
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