The Truth About Defense Contracts: Does Size Matter?

KC-46 with a B-2 Spirit. Image source: Boeing photo illustration.

When you think about defense contracts, what comes to mind? If you answered Lockheed Martin's F-35 fighter jet or Boeing's KC-46A Tanker contract, you're not alone. These two contracts are worth billions, and as such, tend to grab the attention of the media and thereby investors.

However, while contracts such as these have an impact on their respective companies' bottom lines, they're not the be-all and end-all of defense contracts. So the real question is: What should investors be watching?

Don't let size blind you Obviously, these contracts are incredibly lucrative, but they're by themselves not enough to sustain either Lockheed Martin or Boeing. For example, according to its 2014 Annual Report, the F-35 accounted for 17% of Lockheed Martin's total net sales. This means that 83% of Lockheed Martin's total net sales came from something other than its biggest defense contract.

F-35 Lightning II. Image source: Lockheed Martin via Northrop Grumman.

More pointedly, while Lockheed Martin and other defense contractors don't give exact dollar amounts for each of their programs, the truth is that the majority of government defense contracts fall below the $1 billion mark. In fact, because they are scarce, anything that breaches the $1 billion mark is considered a "high priority" contract for defense contractors.

This indicates that while contracts like the F-35 and KC-46A have a more pronounced impact on a company's bottom line than a single $15 million contract for "technical engineering services," smaller defense contracts are also vitally important to a defense company'soverall health, because it's the summation of smaller contracts that make up the bulk of its sales.

Don't invest in a vacuumIt's easy to get caught up in the headlines -- Boeing and its KC-46A billion-dollar cost overrun, the failures of Lockheed Martin's F-35, etc. -- but it's crucial to remember that these contracts don't make or break a company. They have an impact, and should definitely be monitored, but focusing solely on how these billion-dollar contracts are performing, and then investing based on said performance, is a mistake.

F-35 Lightning II. Image source: Lockheed Martin via Northrop Grumman.

Indeed, when evaluating a defense company, it's essential to look at the overall picture. This includes, but is not limited too, monitoring total net sales, profit margins (how much a company is making on the sale of a product after expenses have been deducted), and most important, backlog-- this is effectively all of the contracts that a defense company has on its books. Because the government often awards contracts for products that take defense companies years to develop and then sell to the government, the contract award is initially recorded in a company's backlog. Then, as work is performed and/or deliveries are made, it bills the government, the latter pays the bill, and that amount is recorded as a sale. In this way, backlog is a reflection of a defense company's future work.

What to watch Contracts like the F-35 and KC-46A are impressive, and tend to garner a fair amount of attention partially because of the sheer value of each contract. But it's important to remember that contracts such as these are not the norm, and they don't make up a majority of total net sales.

Consequently, while it's great to monitor these contracts, it's also important to keep in mind that, by themselves, these contracts don't accurately reflect the overall health of a company. In practical terms, this means investors shouldn't invest in a company based on one contract. However, the sum total of contracts can, and should, lead to a more informed investing thesis.

The article The Truth About Defense Contracts: Does Size Matter? originally appeared on Fool.com.

Katie Spence has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.