Given the dual tailwinds of tax reform and solid demand for products and services, the aerospace and defense sector looks primed for yet another outstanding year in 2018. Toss in the ultimate kicker of the U.S. president pushing Congress hard to revamp military spending to upgrade our armed forces, and the proverbial perfect storm could be in place for the sector.
The analysts at RBC are very positive on the industry, and while noting that some valuations are stretched, they also make the case that earnings could rise on average by a stunning 10% due to the newly passed tax reform bill. The report noted this:
While we do not expect celebratory announcements of super-sized buybacks or dividends due to obvious political considerations, the reality is that most of the companies in our coverage have been easily fully funding worthwhile growth investments, and tax reform will produce incremental excess free cash flow that does not need to be reinvested in the business. This extra FCF will therefore probably be used for share buybacks, dividend increases, acquisitions, or pension pre-funding.
Three companies look like solid plays into earnings, and they are rated Outperform at RBC.
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General Dynamics
This company, like other major defense prime contractors, had a very solid year and remains on the best ideas list for the first quarter. General Dynamics Corp. (NYSE: GD) is engaged in business aviation, land and expeditionary combat vehicles and systems, armaments, munitions, shipbuilding and marine systems, and information systems and technologies.
Major products include Virginia-class nuclear-powered submarine and Ohio class replacement, Arleigh Burke-class Aegis, Abrams M1A2 tank, Stryker 8-wheeled assault vehicle, medium-caliber munitions and gun systems, tactical and strategic mission systems.
RBC feels the company has solid potential on a relative valuation basis and explained why:
We consider the company to be an underappreciated beneficiary of tax reform as corporate profitability increases and capex is incentivized, both good for biz jets. Shares have underperformed defense primes by 7% over the past quarter and are cheapest of the primes.
General Dynamics investors receive a 1.62% dividend. RBC has a $246 price target on the shares, while the Wall Street consensus estimate is $234.15. The stock closed Tuesday at $207.48.
CSRA
This company flies somewhat lower on the radar screen and offers investors very solid upside potential. CSRA Inc. (NYSE: CSRA) is a provider of information technology services to the United States federal government. The Company operates through two segments. The Defense and Intelligence segment provides services to the Department of Defense (DoD), National Security Agency, branches of the Armed Forces, and other DoD and intelligence agencies.
The Civil segment provides services to various federal agencies within the Department of Homeland Security, Department of Health and Human Services and other federal civil agencies, as well as various state and local government agencies.
RBC sees this stock as almost a contrarian play and explained why:
Sentiment remains negative, though we see the company as the biggest near-term beneficiary from tax reform based on its prior high-30% tax rate. Organic revenue growth turned positive for the first time last quarter and should accelerate in fiscal third quarter 2018 on the way to a more meaningful uptick in fiscal year 2019. Opportunistic buybacks when the stock was below $30 would be a positive.
Shareholders are paid a 1.23% dividend. RBC has a $41 price objective, while the consensus figure is $36.82. The shares closed on Tuesday at $32.
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Raytheon
This company has a diversified mix of business and remains a favorite at RBC. Raytheon Co. (NYSE: RTN) is an industry leader in defense, government electronics, space, information technology and technical services. The company operates in four principal business segments: Integrated Defense Systems, Intelligence, Information and Services, Missile Systems, and Space and Airborne Systems.
Top Wall Street analysts feel that the company could be one of the biggest winners as the global threat environment has been heightened substantially this year, and with 31% of total sales from international, the prospects remain very positive. Many cite the Patriot Missile deal signed with Poland as a good example, which could propel 2018 earnings.
Raytheon also is expected to be the key supplier for the huge Saudi deal signed last year. The company reported outstanding third-quarter results, and the RBC analysts love the fiscal strength of the company:
Raytheon has the balance sheet capacity to pre-fund its pension to take advantage of the currently-higher tax deduction, which could eliminate or reduce mandatory pension funding and provide a lift to 2019 free cash flow and EPS. It is setup for strong 2018 orders from the wave of recent Foreign Military Sales approvals and strong pipeline of large international missile defense projects.
Shareholders are paid a 1.63% dividend. The $235 RBC price objective is well above the consensus target price of $216.33. The shares closed most recently at $196.23.
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These three top companies to buy in front of earnings should not only have solid short-term results but should lay out good guidance for the first quarter and beyond. All three make sense for growth portfolios looking for aerospace and defense exposure.
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