Better Buy: General Dynamics Corporation vs. Lockheed Martin

Lockheed Martin (NYSE: LMT) and General Dynamics (NYSE: GD) are two of the most interesting defense companies to watch right now, each with an impressive list of programs benefiting from increased Pentagon spending but each with issues that have caused investor concerns.

Following poorly received first-quarter 2018 results from both companies , Lockheed Martin and General Dynamics were both able to paint a rosier picture with their second-quarter results. But after three years of gains, the shares remain in the doldrums, with Lockheed Martin flat for the year and General Dynamics down about 5%.

There is still a lot of money flowing into the defense industry, and Lockheed and General Dynamics remain two of the most compelling options for investors who believe Pentagon funding levels are sustainable for years to come. Here's a look at where both companies stand following second-quarter results. These stats can help you determine which is a better buy.

Branching out

Lockheed Martin is the world's largest defense business, but investors in recent years have become concerned over the company's growing reliance on the F-35 Joint Strike Fighter to hit its revenue targets. The F-35 accounts for about one-third of sales and is only now beginning to ramp up to full production.

The F-35 is a good problem to have, as the advanced attack aircraft is expected to generate more than $1 trillion in revenue for Lockheed and its subcontractors over the next half century. But its high price per plane, about $85 million per frame for the base model, and troubled development history make it a constant target in government budget battles.

Fortunately, Lockheed Martin is making a strong case that it has more going for it than just aeronautics. The company's missile and fire control division saw revenue jump 17% in the second quarter compared to a year prior on the strength of Lockheed's THAAD anti–ballistic missile system and related offerings. Lockheed was also recently awarded $2.9 billion to develop and begin manufacturing a fleet of infrared satellites to replace the U.S.'s aging early-detection and warning system.

Lockheed delivered better-than-expected second-quarter results and raised its total-year sales and net income forecast because, as CFO Bruce Tanner told analysts during a call, the company is simply winning a lot more business than it had forecast.

One area in which Lockheed Martin seems poised for further growth is hypersonics , missiles able to travel more than five times the speed of sound. Since April, the company has won two major development competitions, worth a combined initial $1.4 billion, and commentary from the Pentagon concerning those awards suggests Lockheed Martin is substantially ahead of its rivals in hypersonic R&D.

Given that the Pentagon has made hypersonics a major priority, considerably more funding is expected to flow into new missile development in the years to come. Lockheed Martin won't win all that business, and even if it did, it would not be enough to put missiles on par with aeronautics, but the unit is developing into a solid growth engine inside the company.

Steadying the ship

General Dynamics is one of the nation's two largest shipbuilders, a manufacturer of a range of Army and Marine land-based weapons platforms, and is a leader in government IT, but investors in recent years have been more focused on the company's struggling commercial aerospace unit.

Gulfstream has been mired in a now decade-long slump in business jet sales. Industrywide global annual business jet sales in 2016 were less than half the total from 2008, according to the General Aviation Manufacturers Association, and Gulfstream saw its sales drop by more than 20% over that time period.

The weakness at Gulfstream has caused General Dynamics to underperform its defense rivals, with its shares up "only" 32% over the last three years (Lockheed shares are up nearly 58% over that period). But there are increasingly signs that the worst is over for Gulfstream. The unit reported a 1.3-times book-to-bill ratio in the second quarter, up from a disappointing 0.77 times in the first quarter, as a combination of an aging corporate fleet and changes to depreciation contained within this year's tax-reform package have business jet users shopping again. Gulfstream second-quarter unit orders were up 21% from a year prior.

Gulfstream has new models on the way, with its G500 just recently certified and the larger G600 hoping to achieve that milestone before year's end. As those models hit the market in 2019, there will be ramp-up costs that will eat into initial profitability, but the stage is set for Gulfstream's sales and margins to improve over time. As they do, the stock should react positively.

The General Dynamics defense businesses remain healthy, with organic defense revenue up 7.1% year over year in the recently completed quarter. The company, thanks to its $9.6 billion acquisition of CSRA earlier this year, is well positioned to tap into the significant pent-up demand for government IT modernization, and its shipbuilding arm should benefit from the Pentagon's push to upsize the Navy.

And the better buy is...

I've had General Dynamics as my best buy among the defense primes for some time now, but I must admit the Lockheed Martin quarter and outlook have me questioning that stance. Lockheed has a hand in almost every area deemed a Pentagon priority, and if its second-quarter success winning contracts turns into a trend, the company will outperform. It also has the highest dividend yield among defense majors.

For now, though, General Dynamics remains the better buy. Lockheed Martin is by far the more richly valued of the two stocks, trading at 36 times trailing earnings compared to GD's 19 times. And while Lockheed Martin's recent wins suggest the company can justify that valuation and perhaps over time continue to creep higher, General Dynamics's opportunity to get Gulfstream back on track is the easiest path to multiple expansion I see among defense contractors.

The Gulfstream recovery will be slow and perhaps choppy, but I believe Wall Street will see concrete signs of a sales recovery in the quarters to come and begin to be more comfortable with General Dynamics shares.

As Gulfstream gains elevation, so too will shares of General Dynamics. GD is still the better buy.

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Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.