The Case Against Defense Stocks

Brit Ryle

Posted July 17, 2023

Last week, the U.S. said it would send “cluster bombs” to Ukraine for its fight against Russia. There was a pretty significant backlash to the announcement, because cluster bombs leave a pretty nasty legacy…

A cluster bomb is one big bomb that’s filled with as many as 2,000 smaller bombs. The idea is that the smaller bombs scatter in a wide range to inflict maximum damage to an enemy force. The problem is that all the little bombs don’t always explode right away. In fact, you can pretty much count on some of the small bombs to land undetonated – failure rate can be as high as 5%. 

They can then sit undetonated for years after a conflict is over – until some hapless civilian unknowingly disturbs it. 

It is that risk to civilians that prompted 108 countries to sign the Convention on Cluster Munitions that banned their use. Of course, the U.S., Russia and China didn’t sign the agreement – though the U.S. has had a “prohibition on operational” use of cluster munitions since 2003. 

Still, a lot of people think it’s not ok to send that kind of weapon to Ukraine.

But what bothered me more about the decision to send cluster bombs to Ukraine is the reason why…?

A headline from the New York Times on July 10 sums it up: America Is Running Out of Ammo

President Biden told CNN that: “The Ukrainians are running out of ammunition… and we’re low on it.”

Check this out from that NYT article: 

In a war game for control of … [Taiwan] that the House Select Committee on China played this year, the U.S. ran out of long-range antiship weapons in three days. Retired Navy Rear Admiral Mark Montgomery says in most games the U.S. needs roughly 1,200 long-range antiship missiles, known as LRASMs. But U.S. inventories are in the low hundreds after years of small orders.

Now there is a push to restock the military’s depleted supplies. Right now, 14,000 standard 155mm artillery shells are being produced a month. The Army is spending to get the production up to 24,000 shells a month, with a target of getting to 85,000 shells a month – in 5 years time.

The Army is also trying to get production of Stinger missiles up from 45 a month to 60 – by 2025. 

Patriot missile systems production is expected to expand to – 12 by the end of this year. 

Couple things…

One, I understand the world changed when Russia invaded Ukraine. That was a true wake up call for the U.S. and Europe about the need for more military supply. But change doesn’t necessarily come fast to the military-industrial complex.

Two, it appears to me that some of these production increases are kind of small. I mean, seems like you could increase Stinger missile systems by more than 15 over the next year and a half…

Which begs my final question: what is going on with U.S. defense contractors? Why are they not taking advantage of the most bullish climate for defense since the Reagan years?

Opportunity Knocks

I check in on defense stocks every once in a while, cuz I keep thinking at some point, the macro environment will look favorable for them and they will start moving…

They never do.

Raytheon (NYSE: RTX) makes Stinger and Patriot missile systems. On February 24, 2022, the day Putin sent Russian troops into Ukraine. Raytheon closed at $90 a share. Today it trades at $96.50. Not even a 10% gain in a year and a half of war in Europe. 

Of course Raytheon has been as high as $105 since the war in Ukraine began. It’s also been as low as $80.

Lockheed Martin (NYSE: LMT) makes drones and the HIMARS rocket system. In the three days after the invasion began, shares of Lockheed Martin ran from $395 to $456. It sits at $472 today. So if you didn’t buy it immediately after Putin invaded, you missed the boat.

General Dynamics (NYSE: GD) is one supplier of those 155mm artillery shells. Abrams tanks and Stryker fighting vehicles, too. The stock closed at $218.53 on February 24, 2022. Today the stock trades for $216.80. It’s actually lower than it was when the war in Ukraine began! 

What is going on with defense stocks?

Downgraded Defense

When I went to review defense stocks (again) over the weekend, I was expecting to find something exciting, especially with what’s been said about U.S. military supplies recently. 

I was disappointed. 

Part of the reason is the result of the Debt Limit Bill (remember that?) that capped defense spending for the next two years.

Plus, the New York Times article I cited above adds that: “.. Congress is squabbling over the fixed pie…The House Appropriations Committee is declining to fund bulk buying of two crucial precision weapons—the Standard Missile-6 and an air-to-air AMRAAM missile. GOP appropriator Ken Calvert told us the Pentagon didn’t show sufficient savings and that contractors are struggling to fill their orders.

The thing is, defense contractors need bulk purchase orders. Because many of the smaller parts and subsystems are farmed out to smaller companies. Those smaller companies can’t make big investments in their own staff and manufacturing capacity unless they have some certainty about incoming orders and revenue. 

And so if Congress decides to dole out orders on a piecemeal basis, well, it’s going to make the production ramps that need to happen much more difficult. 

Some (Lame) Growth Numbers

And so the outlook for defense contractors just isn’t that great.

Lockheed Martin is expected to grow revenue from $65.8 billion this year to $67.8 billion next year. Earnings will grow less than a dollar per share, from $27.15 to $28.09.

Raytheon looks a bit better. It should grow revenue from $72.7 billion to $78.4 billion. Better, but that’s still not 10% growth. Earnings per share should go from $5.02 to $5.77, but with the stock already trading at 19 times next year’s earnings, it’s just not very compelling.

If I had to pick one, it would be General Dynamics. Revenue growth is expected to be less than 10% like the others – $41.5 billion this year to $44.3 billion next year. But at least GD has some real earnings growth – $12.64 a share this year and $14.78 next year.

General Dynamics pays a 2.45% dividend and a low payout ratio of 30%. Throw the potential for a dividend hike in with the forward P/E of 17, and I could see maybe a 25% move for the stock over the next year, but that’s about it.

Sorry to disappoint, but I think there’s better places for your money than defense stocks. Still, I’ll be watching to see if Congress gets a little more serious about our defense needs…

That’s it for me today. Take care and I’ll talk to you Wednesday..

Briton Ryle
Chief Investment Strategist
Pro Trader Today