Better Buy: Raytheon Company (RTN) vs. Northrop Grumman (NOC)

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Raytheon (NYSE: RTN) and Northrop Grumman (NYSE: NOC) are two well-run defense contractors who have been on a roll since the 2016 election, with shares up 61% and 54%, respectively, since November 2016. They also both now trade at price-to-earnings and price-to-sale ratios well above 10-year norms as a result.

Increased Pentagon spending, the impetus behind the stock surge, is finally becoming a reality with lawmakers in February finally reaching a deal on a long-term budget. The question is whether it is too late for investors to jump in and buy one or either of these companies. Here is a comparison of Raytheon and General Dynamics to try to determine which is the smarter pick now.

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Market Cap

2017 Sales

Price-to-Sales Ratio

TTM PE Ratio

TTM Dividend Yield

Raytheon

$63.46 billion

$25.35 billion

2.50

31.66

1.46%

Northrop Grumman

$61.66 billion

$25.8 billion

2.39

30.88

1.11%

Raytheon: Right on target

Raytheon, at $25.3 billion in sales, has a commanding presence in most of the areas of greatest interest to the Pentagon including precision weapons, anti-missile systems, electronic warfare systems, and sensors and radars. The company also records about one-third of total sales outside of the United States, making it one of the most diversified U.S. defense contractors.

The company's Patriot missile systems are the first line of defense in the Middle East and gaining popularity elsewhere, and it is also responsible for the radars used by Lockheed Martin for its THAAD anti-ballistic system that is being deployed to counter North Korean threats. Raytheon ended 2017 with a $38.2 billion backlog, up 4% from a year prior, and in January predicted it will grow cash from operations by more than 40% in 2018, including the benefit of tax reform.

Raytheon also has a large cybersecurity unit, the result of a 2015 deal to combine its internal IT business with commercial vendor Websense. That business, now known as Forcepoint, has so far failed to live up to expectations, but the company continues to revamp the operations in hopes of jump-starting growth at what could be a hidden gem inside Raytheon's portfolio.

Raytheon's board in November authorized a new $2 billion share buyback on top of the $900 million available at the time under a 2015 program, continuing a trend that has seen it reduce its share count by about 30%. Investors are expecting a dividend hike this spring, in keeping with what has become an annual tradition for the company.

A streamlined fighting machine

Northrop Grumman is a $25.8 billion-sales maker of bombers, drones, radars, sensors, and tech systems for the U.S. government and allied customers. The company in 2011 spun off its massive shipbuilding operation as Huntington Ingalls Industries, and in the years since, it has focused primarily on higher-tech -- and hopefully higher-margin -- systems development, including developing some of the brains behind aircraft and ships made by rival contractors.

Northrop of late has been selective about what contracts it competes for, a welcome development for investors who want to make sure management is prioritizing profitability over generating headlines in an increasingly competitive business.

The company's next big hit figures to be the still-under-development B-21 bomber, designed to be a long-range, stealth workhorse for the Air Force capable of delivering nuclear and conventional weapons wherever needed. The Pentagon is expected to buy at least 100 aircraft priced at more than $500 million apiece beginning in the mid 2020s, with the program expected to generate as much as $80 billion for Northrop and its subcontractors over its lifetime.

Northrop is also focused on space, with plans to massively increase its expertise in the coming months when it closes its $7.8 billion deal for Oribtal ATK. The combination will create a one-stop shop for sensors, satellites, and launch services along with adding Orbital's munitions business. The deal should also put Northrop in a prime position to compete for future contracts including the Ground Based Strategic Deterrent program, a plan to modernize the U.S. stockpile of intercontinental ballistic missiles, which could be worth upwards of $85 billion to contractors.

The company had a poor showing in the final months of 2017, attributable primarily to adjustments due to changes in U.S. tax laws, but it expects 2018 earnings to be up nearly 33% from 2017 on sales 5% higher.

Which is a better buy?

At current valuations, neither Raytheon nor Northrop Grumman are a bargain, and it is understandable if most investors would conclude that today, these are both better holds than buys. For those wanting to put new money at work, Raytheon seems to be the better buy for 2018, but Northrop Grumman the better buy for long-term holders.

While 2018 is more of a transition and integration year for Northrop Grumman, with the company focused on integrating Orbital and advancing the B-21 and other future programs, Raytheon, with its exposure to missile defense and cyber, figures to be more the subject of headlines -- and therefore could be the beneficiary of further momentum buying.

Northrop is making smart moves, but those moves will take time to bear fruit. The company is best bought by investors who don't mind a little bit of a wait.

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