Four Defense Stocks for Income Investors to Purchase as China Escalates Threats
By: Paul Dykewicz,
The four defense stocks for income investors to purchase are based in the United States, have a track record of paying dividends and are highly recommended by seasoned stock pickers. They also may gain additional orders in the future with China raising tensions particularly in the Asia-Pacific region by sending 56 of its military jets into neighboring Taiwan’s air space on Oct. 4 in a show of force.
Between Oct. 1 and Oct. 4, a total of 145 Chinese air force planes flew into Taiwan’s air defense identification zone (ADIZ) in hostile acts to challenge Taiwan’s sovereignty. U.S. President Joe Biden met with China’s President Xi Jinping in a three-and-a-half hour virtual summit on Nov. 16 that ended with both leaders still at odds with the policies of the other. Even though China describes Taiwan as a breakaway province to be reunified with the mainland one day, the United States has pledged to help Taiwan defend itself in the event of an attack but also recognizes and has formal ties with China.
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Military Contracts Could Lift Four Defense Stocks For Income Investors to Purchase
Australia is another Asia-Pacific country whose leaders have accused China of threatening it through trade strikes. In addition, Australia’s former Prime Minister Tony Abbott said Chinese officials are trying to bully Taiwan and potentially lash out aggressively with disastrous consequences if it is not stopped.
As part of Australia’s plan to strengthen its national defense, the country’s Prime Minister Scott Morrison announced in October that at least eight nuclear-propelled submarines using American or British technology will be built in Australia to begin serving the country in the late 2030s. France’s ambassador to Australia, Jean-Pierre Thebault, said on Nov. 3 that Australia acted with deceit when it abruptly cancelled a multi-billion dollar pact with Paris to build a fleet of submarines, then agreed to a rival deal with the United States and the United Kingdom.
BofA Global Research defense and aerospace analyst Ron Epstein wrote a research note on Nov. 15 that predicted future U.S. defense spending may be spurred by the increasing frequency of China’s territorial claims. Epstein elaborated that America’s defense spending will become less cyclical, have an absolute floor and likely continue to grow.
Allied Military Spending Aids Four Defense Stocks for Income Investors to Purchase
The U.S. House of Representatives passed the National Defense Authorization Act (NDAA) with bipartisan support to increase spending to approximately $740 billion. Although China’s exact defense spending is unknown due to its leaders’ secrecy, the Stockholm International Peace Research Institute (SIPRI) estimates the country in 2020 accounted for 13%, or about $252 billion, of the world’s $1.981 trillion in global military spending, with the United States totaling 39%.
When adjusted for military purchasing power parity (PPP), China’s defense spending is around 55-75% of the United States’, Epstein estimated. But defense spending does not directly equal military power, since intangibles such as alliances, modernization of equipment, unmanned vehicles and original technologies rather than acquired intellectual property factor into it.
China’s military expenditure, the second-highest in the world, is estimated to have totaled $252 billion in 2020, marking a rise of 1.9% from 2019 and 76% over the decade 2011–20, according to the SIPRI. China’s military spending has risen for 26 consecutive years, the longest series of uninterrupted jumps by any country in the SIPRI Military Expenditure Database.
Lagging defense stock valuations are missing the fundamental shift as the market has been focused on short-term budgetary concerns, Epstein wrote. In that regard, defense stocks should do well in the next few years.
Pension Chairman Chooses Favorite of Four Defense Stocks for Income Investors to Purchase
“The U.S. defense budget will increase despite the withdrawal from Afghanistan as policy shifts toward containing China and Russia,” said Bob Carlson, who leads the Retirement Watch newsletter. “Defense stocks sell at solid valuation discounts to the S&P 500, despite having higher estimated earnings growth than the S&P 500.”
Carlson, who also serves as chairman of the Board of Trustees of Virginia’s Fairfax County Employees’ Retirement System with more than $4 billion in assets, said that his preferred defense stock is Raytheon Technologies Corporation (NYSE: RTX). The Waltham, Massachusetts-based company’s earnings for 2022 are likely to increase more than the other companies in the sector, he added.
Even so, Raytheon’s share price has been in a trading range since June, Carlson commented. The stock also is recommended by BofA.
Raytheon Leads List of Four Defense Stocks for Income Investors to Purchase
Raytheon Technologies, the world’s second-largest aerospace & defense company, came into existence through the all-stock merger of equals between Raytheon and United Technologies on April 3, 2020.
The combined company has four operating units: 1) Pratt & Whitney, a maker of military and civil aircraft engines and provider of service operations, 2) Collins Aerospace Systems (interiors, aviation controls and systems), 3) Intelligence, Space & Airborne Systems and 4) Integrated Defense & Missile Systems.
BofA’s price objective of $110 for Raytheon is based on a discounted cash flow (DCF) analysis that factors in a discount rate of 10% and a 7% next-five-year growth rate. The investment firm noted that Raytheon’s free cash flow (FCF) assumptions do include the potential impact of the research and development (R&D) amortization tax change, since BofA prefers to forecast conservatively.
Risks to BofA’s price objective are a downturn in commercial aviation due to the natural business cycle or an exogenous event such as a terrorist attack or a worsening pandemic. A severe global economic slowdown would affect top-line growth as 45% of Raytheon’s sales are produced outside the United States.
Four Defense Stocks for Income Investors to Purchase Incur Execution Risks
Execution risks on defense programs always can cause cost overruns and margin contractions, BofA noted. Plus, orders from international programs are difficult to time due to the complexity of the process.
As a result, international orders could show some “lumpiness,” Epstein wrote. Unexpected cancellations to programs in both commercial and military manufacturing may materially impact Raytheon’s share price, he added.
Potential catalysts that could help Raytheon outperform BofA’s estimates of the manufacturer’s price objective include commercial aerospace and business aviation jets beating expectations and earnings faring better than the investment firm projects. If margins top BofA forecasts, there could be upside potential for its valuation of Raytheon. In addition, if the company executes on its existing programs better-than-expected, market share gains in the international market or a materially accretive acquisition could propel the share greater-than-anticipated, Epstein wrote.
Chart courtesy of www.stockcharts.com
Market Veteran Picks One of the Four Defense Stocks for Income Investors to Purchase
Reston, Virginia-based General Dynamics (NYSE: GD), the world’s third-largest defense and aerospace company, is a recommendation of veteran stock picker Jim Woods. A former U.S. Army paratrooper, Woods chose General Dynamics as one of the stocks in his Intelligence Report newsletter’s Income Multipliers Portfolio. Woods also leads the Successful Investing newsletter, as well as the Bullseye Stock Trader advisory service.
General Dynamics has produced a five-year average return of 27%, the best of any of five industrial stocks in that portfolio. The company is up 36.7% so far this year. Income investors may appreciate that General Dynamics has been paying a dividend since 1979.
Paul Dykewicz interviews Jim Woods, who leads Intelligence Report.
Four Defense Stocks for Income Investors to Purchase Include General Dynamics
BofA gave General Dynamics a price objective of $260, using a two-stage DCF analysis which assumes a 9.3% discount rate, 5.2% 2025-2030 growth rate and 2.7% long-term growth rate to reflect the added benefit of Gulfstream G400/G800 business jet deliveries. The investment firm forecasts that the company’s defense program exposure, especially in its Marine unit, coupled with Gulfstream, could provide near-term and medium-term organic growth.
Additionally, the company’s strong balance sheet and solid cash generation could sustain dividend growth and share repurchases, Epstein added. But the forecast is not without risks.
Potential downsides to the stock reaching BofA’s price target include: 1) A downturn in business jets, due to an exogenous factor, 2) An unexpected devaluation in the dollar significantly impacting order activity, since business jets are priced in dollars, 3) Poor execution on defense programs adversely impacting margins, 4) Any defense budget cuts hurting growth in the medium- and long-term.
Chart courtesy of www.stockcharts.com
Northrop Grumman Nets Spot Among Four Defense Stocks for Income Investors to Purchase
Northrop Grumman (NYSE: NOC), a Falls Church, Virginia-based multinational aerospace and defense technology company, employs 90,000 people and produced more than $30 billion in annual revenue. It also is one of the world’s largest weapons manufacturers and military technology providers.
BofA gave Northrop Grumman a price objective of $460, based on a DCF analysis that reflects a 4% year over year (Y/Y) growth rate for 2025-2030 estimates, a 2.5% long-term growth rate and an 8.3% discount rate. The U.S. Defense Budget Authorization has grown at a 1.8% compound annual growth rate (CAGR) in constant dollars since post World War II.
Since the most profitable production phase of the B-21 Raider program starts in about 10 years and the Ground Based Strategic Deterrent (GBSD) will enter production at the end of this decade, BofA expects Northrop Grumman’s next terminal growth rate could top the pace of historical growth in U.S. defense spending. The GBSD is a future American land-based intercontinental ballistic missile system currently in the early stages of development to replace the aging Minuteman III missiles.
Downside risks to BofA’s price target could come from any execution problems with defense programs that cause cost overruns and margin contractions, as well as unexpected cancellations.
Chart courtesy of www.stockcharts.com
L3Harris Lands on List of Four Defense Stocks For Income Investors to Purchase
L3Harris (NYSE: LHX), a Melbourne, Florida-based defense contractor and information technology services provider, produces command, control, communications, computers, cyber-defense, combat systems (C6) and intelligence, surveillance and reconnaissance (ISR) systems and products. The company further offers wireless equipment and tactical radios.
BofA’s price objective of $251 for L3Harris puts the company’s valuation in line with the defense industry’s pure play average along with Lockheed Martin (NYSE: LMT) and Northrop Grumman. Potential for outperforming BofA’s price objective could come from L3Harris winning new and existing programs versus the investment firm’s expectations.
Downside risk to BoA’s price target could stem from L3Harris not integrating the operations of L3 Technologies and Harris Corporation as expected. The companies merged on June 21, 2019, but any continuing integration challenges could put a strain on cash and impact BoA’s free cash flow estimates.
Chart courtesy of www.stockcharts.com
Hybrid Company Offers Alternative to Four Defense Stocks For Income Investors to Purchase
Albany International Corp., (NYSE: AIN), headquartered in Rochester, New Hampshire, operates 23 facilities in 11 countries, as well as employs approximately 4,000 people worldwide. The company is a global advanced textiles and materials processing company that also serves the defense industry.
Albany International develops and manufactures engineered components, using advanced materials processing and automation capabilities, with two core businesses. They are:
- Albany Engineered Composites, a growing designer and manufacturer of advanced materials-based engineered components for demanding aerospace applications, supporting commercial and military platforms.
- Machine Clothing, one of the world’s largest producers of custom-designed, consumable belts that are essential for the manufacture of all grades of paper products.
BofA’s price objective of $105 accounts for the differing valuations of both units. The valuation of Albany Engineered Composites is slightly higher than the other business segment and is comparable to other aerospace peers, Epstein wrote.
Risks to the price objective are that the Machine Clothing segment is AIN’s primary driver of cash. Global slowdown in paper production or disruption in the production of paper could hurt the company’s profits and cash profile, according to BofA.
In addition, a disruption in cash generation in Machine Clothing could hinder management’s ability to invest in aerospace and defense. A commercial aerospace downturn that affects narrow body aircraft that have the CFM International LEAP engine could materially affect Albany International. Unexpected cancellations to programs in both the commercial and military segments could materially impact the company, too.
Upside to BofA’s price target could come from the Airbus A320neo, Boeing 737 MAX and Comac C919 announcing increasing production rates. The company would benefit as a sole-sourced supplier to the CFM LEAP engine and might exceed the BofA estimates. Increased scope of work on existing programs or any new program wins could provide upside to Albany International in the medium term.
Albany International’s 0.9% dividend yield is just half the 1.8% yield of Northrop Grumman. The 1.9% dividend yield of L3Harris is the next highest, while Raytheon and General Dynamics tied for the lead among the four defense stocks for income investors to purchase with a dividend yield of 2.4%.
Chart courtesy of www.stockcharts.com
Four Defense Stocks For Income Investors to Purchase Undeterred by COVID-19 Risk
The highly transmissible Delta variant of COVID-19 has continued to plague the United States with new cases and deaths. It remains a huge concern for public health experts who keep urging increased vaccinations and booster shots, as well as widespread mask wearing.
The Centers for Disease Control and Prevention (CDC) specifically has blamed the variant for unleashing a surge of cases and deaths early in the fall. However, the variant also is leading to a rise in the number of people vaccinated from COVID-19.
As of Nov. 19, 228,570,531 people, or 68.8% of the U.S. population, have received at least one dose of a COVID-19 vaccine, the CDC reported. The fully vaccinated total 195,731,107 people, or 58.9%, of the U.S. population, according to the CDC.
Worldwide COVID-19 deaths, as of Nov. 19, topped the 5 million mark, hitting 5,138,066, according to Johns Hopkins University. Global COVID-19 cases topped 250 million, hitting 256,484,375, as of that date.
U.S. COVID-19 cases, as of Nov.19, reached 47,588,874 and caused 769,654 deaths. America has the dreaded distinction as the nation with the most COVID-19 cases and deaths.
The four defense stocks for income investors to purchase seem primed to profit from the mounting conflict between China and a growing number of other countries whose governments are stepping up military spending to counter the threat.
Paul Dykewicz, www.pauldykewicz.com, is an accomplished, award-winning journalist who has written for Dow Jones, the Wall Street Journal, Investor’s Business Daily, USA Today, the Journal of Commerce, Seeking Alpha, GuruFocus and other publications and websites. Paul, who can be followed on Twitter @PaulDykewicz, is the editor of StockInvestor.com and DividendInvestor.com, a writer for both websites and a columnist. He further is editorial director of Eagle Financial Publications in Washington, D.C., where he edits monthly investment newsletters, time-sensitive trading alerts, free e-letters and other investment reports. Paul previously served as business editor of Baltimore’s Daily Record newspaper. Paul also is the author of an inspirational book, “Holy Smokes! Golden Guidance from Notre Dame’s Championship Chaplain,” with a foreword by former national championship-winning football coach Lou Holtz. The book is great as a gift and is endorsed by Joe Montana, Joe Theismann, Ara Parseghian, “Rocket” Ismail, Reggie Brooks, Dick Vitale and many others. Call 202-677-4457 for multiple-book pricing.