U.S. defense contractors work closely with the U.S. government to develop new products and services. From jets, tanks, and ships to satellites, missiles, nuclear efforts, tech, and more, the defense industry has a lot of moving parts and is constantly innovating.
Defense contractors can be reliable investments due to their sizable backlogs and stable earnings, which are ideal for supporting dividend growth. However, there is political risk in investing in this industry because of its dependence on increased government spending.
RTX(NYSE: RTX), Lockheed Martin(NYSE: LMT), and L3Harris Technologies(NYSE: LHX) are three top defense stocks that play integral and unique roles in the defense industry. Here's why each company is a great way to invest in the industry.
A mix of aerospace and defense supports RTX's growth
Lee Samaha(RTX): Aerospace and defense giant RTX's 2023 has been full of plot twists and turns. This was supposed to be the year when its aerospace revenue and earnings would take off in line with a robust recovery on commercial aerospace, ably supported by a gradual easing of challenging supply chain conditions in its defense businesses, allowing it to expand margins and take advantage of its robust backlog.
Some of that has come true. RTX's commercial aerospace-focused businesses, Collins Aerospace and Pratt & Whitney, are set for double-digit growth this year and are exceeding expectations set at the start of the year.
However, the discovery of potential contamination in powder coating used in Pratt & Whitney engines means the company will suffer a $3 billion hit to its free cash flow (FCF) between 2023 and 2025 as it needs to remove and inspect engines. In addition, management recently lowered its full-year profit expectations in its defense-focused Raytheon business due to persistent cost inflation and supply chain issues.
The powder coating issue was first disclosed in July. Then, management disappointed the market by announcing the hit would be worse than initially expected in September. That led to fears that the issue could morph into something even more significant. However, the recent update saw management finalizing the charge in line with what it said in September.
After the dust settles on an up-and-down year, RTX's backlog stands at a record $190 billion, driven by robust orders growth, and is set for FCF of $4.8 billion in 2023, leading to $7.5 billion in 2025. Hitting the 2025 target would put RTX on a price-to-FCF multiple of just 15.2 times FCF. By then, the supply chain issues should have eased significantly, and RTX can continue delivering on its multiyear backlog. Throw in a near 3% dividend yield, and the stock is attractive for investors.
A balanced industry-leading defense stock
Daniel Foelber (Lockheed Martin): When it comes to defense stocks that pay a growing dividend, there is no better option than Lockheed Martin.
United Technologies, which merged with Raytheon to form RTX in 2020, cut its dividend in 2007. Northrup Grumman(NYSE: NOC) and Raytheon raised their dividends every year since 2005. But Northrup's raises haven't been as sizable as Lockheed's, and the stock yields just 1.6%. RTX has made some solid raises, and the stock has a yield of 2.8%, which Lockheed Martin matches.
On Oct. 6, Lockheed raised its quarterly dividend to $3.15 per share, making 2023 the 21st consecutive year it has raised its dividend.
The investment thesis for Lockheed Martin is straightforward. It has an excellent track record of dividend raises and an attractive yield. It has a massive backlog of $156 billion and a well-diversified business featuring four segments -- aeronautics, missiles and fire control, rotary and mission systems, and space. And no segment makes up more than 40% of Q3 revenue or operating profit. Lockheed Martin isn't an expensive stock, either, with a price-to-earnings ratio of just 16.7. And finally, Lockheed has an industry-leading operating margin of 12.6%.
A high operating margin is important for Lockheed Martin, considering its low revenue growth over the past several years. The operating margin helps support Lockheed's growing dividend and share buyback program. All told, Lockheed checks all the boxes of what to look for from a defense stock.
Strong backlog growth is only one reason L3Harris should be a target for defense-oriented investors
Scott Levine (L3Harris Technologies): Investors looking to fortify their portfolios with a defense stock have a variety of choices. Generating decent passive income from defense stocks is a slightly taller order since many companies in the industry pay uninspiring dividends that fall far short of the S&P 500's 1.6% yield. L3Harris Technologies, however, rewards shareholders with a 2.5% forward dividend yield and does so from a strong financial position.
Specializing in systems found in space, on the sea, in the air, and on land, L3Harris' presence is found on a variety of battlegrounds. According to management, the strong performance throughout the company's portfolio has contributed to L3Harris upwardly revising its 2023 revenue guidance from an original forecast of approximately $17.6 billion to about $18.15 billion. But it's other areas in the company's financials that suggest L3Harris is a compelling choice for defense-minded investors.
For one, the company has benefited from strong backlog growth, exiting the second quarter of 2023 with a backlog 25% higher compared to the same period last year -- a green flag for those concerned about the company sustaining its dividend. Furthermore, L3Harris doesn't jeopardize its financial fortitude to reward shareholders. Over the past five years, it has averaged a cautious payout ratio of 52%, and the company ended Q2 2023 with a conservative net debt-to-adjusted earnings before interest, taxes, depreciation, and amortization ratio of 2.5.
Currently, shares of L3Harris are priced at 16.3 times operating cash flow. While the stock may not seem like a screaming buy at this valuation, it's worth noting that the price tag doesn't represent a discount based on the stock's five-year average operating cash flow multiple of 18.8.
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Daniel Foelber has no position in any of the stocks mentioned. Lee Samaha has no position in any of the stocks mentioned. Scott Levine has no position in any of the stocks mentioned. The Motley Fool recommends Lockheed Martin and RTX. The Motley Fool has a disclosure policy.