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Getting Ready To Attack The Defense Stocks: General Dynamics Corporation (GD) and More

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It seems the political battle over government spending is about to heat up again. After a month and a half respite, this latest round of squabbling centers on the $1.2 trillion sequester, a mandated across-the-board set of spending cuts. If enacted, the sequester is expected to hit U.S. defense spending hard. Leon Panetta, outgoing Secretary of Defense, said that if the billions of dollars in cuts are allowed to stand he would have to throw the country’s national defense strategy “out the window,” and the United States would no longer be a first-rate power.

Anxieties about the defense stocks will likely increase as politicians negotiate and the March 1st sequester deadline approaches. Share prices should fall and excessive fear might create an attractive buying opportunity.

General Dynamics Corporation (NYSE:GD)In anticipation of a potential defense stock purchase, three main questions need to be considered:

1. Are their long-term prospects decent?

The defense stocks, namely Northrop Grumman Corporation (NYSE:NOC)Raytheon Company (NYSE:RTN)Lockheed Martin Corporation (NYSE:LMT), and General Dynamics Corporation (NYSE:GD), have already been under pressure due to expected revenue loss from winding up operations in Afghanistan and other recent cuts.

Northrop Grumman, after adjusting for the spin-off of its shipbuilding business, has seen the share price fall from a 2007 high of $85 to a low of $61 in 2012. Raytheon has had a similar drop from $65 to a $47 per share low. Lockheed Martin and General Dynamics were not immune with their stocks falling 30% and 35%, respectively, from 2007 highs.

But there is a compelling argument that the future might not be so dire.

Military power is likely to be a growing strongpoint for backstopping America’s interests overseas. Our dominant economic power was an effective instrument in dealing with other nation states for many years, but now with vibrant growth in the emerging markets, it seems this power does not have the punch it once had. The nominal effect of some extremely harsh sanctions on Iran and North Korea is an example of the current limitations of economic persuasion.

Another example of military power likely dominating economic strength in supporting U.S interests can be seen in the Department of Defense (DOD) strategy of focusing on Southern Asia. While the U.S. can offer some economic benefit to the countries in that region, it seems clear that our ability to offer a territorial defense will garner the closest ties.

Besides China’s fragile relations with its Asian neighbors, instability in North Africa, friction in the Korean peninsula and expanding tension in the Middle East also increase the chance that the U.S. will eventually have to exhibit its military resource.

2. What’s their risk from the sequester?

The sequester and other identified cutbacks look to reduce defense spending by about $850 billion over a ten year period or $85 billion a year. Since total U.S. defense spending runs about $1.1 trillion per year that would be a cut of roughly 8%.

If we concentrate only on the DOD’s portion of spending or around $700 billion per year, a direct $85 billion hit comes to about 12%. Thus, expecting a 12% reduction in annual revenues might be a reasonable benchmark for defense company risk.

3. What’s their fair value?

Northrop Grumman Corporation (NYSE:NOC)

Northrop Grumman had $25.2 billion in revenue in 2012 with a reported net profit margin of 7.8%. Assuming a 12% cut to revenues and a drop in margin to 6.9%, or sales of $22.5 billion and average adjusted cash earnings of $1.7 billion, Northrop looks to have a fair business value of around $80 per share based on a 12x multiplier.

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