My Best Defense Stock to Buy in 2021 - The Motley Fool

We're just a week in and 2021 is already quite a different market than last year. Many oil and gas companies are up double digits as WTI crude oil rocketed past $50 a barrel. Tech stocks are underperforming the market, and investors are questioning the valuations of expensive stay-at-home companies.

Like energy, the aerospace and defense sector heavily underperformed the market last year. Many leading companies fell over 10% despite the S&P 500's over 15% gain. One of the largest pure-play defense contractors, Lockheed Martin (NYSE:LMT), was no exception and fell 9% last year. 

Trading at a P/E ratio of just 15 with a dividend yield of over 3%, Lockheed is shaping up to be an excellent value investment in 2021. Here's what makes it a great buy now.

Image source: Getty Images.

An out of favor sector

The aerospace and defense sector is out of favor for a number of reasons. On the aviation side, the commercial airline industry continues to struggle. Air traffic is down over 50% from early 2020 levels, which affects commercial aircraft producers like Boeing and systems and components suppliers like Honeywell. As a pure-play defense contractor, Lockheed isn't hurting from this headwind.

Looking further ahead, the U.S. budget can be a great resource because it forecasts 10 years out. For fiscal year 2021, which began Oct. 1, 2020, the forecast calls for $753 billion in defense spending. In 2030, that number is projected to grow to $913 billion. This may sound like a lot, but it's actually only about a 2% increase per year. 

Looking at the macro short-term and long-term growth prospects, there is little argument that the defense sector isn't exactly teeming with growth. Contrasting with this negativity is the fact that Lockheed just notched its highest quarterly revenue ever and is expected to finish 2020 with near-record profit and operating cash flow. It also has a record backlog of over $150 billion, which gives it a reliable source of future revenue. However, its guidance suggests a mere 2% increase in sales in 2021. 

Growth prospects

With a low growth forecast in a low growth industry, investors are probably curious to know what Lockheed's top growth prospects are. The company has been investing heavily into its space segment, making multi-billion dollar deals to further dominate the hypersonic (missiles) market. With a FY 2020 budget of $2.6 billion and a FY 2021 request of $3.2 billion, the hypersonic budget is one of the faster-growing investments on the Pentagon's radar. 

On Tuesday, Lockheed landed a $4.93 billion deal from the Space and Missile Systems Center at Los Angeles Air Force Base in California for three next-generation geosynchronous Earth-orbiting space vehicles. In addition to building the vehicles, Lockheed will provide software and support services. Contracts like these extend over several years and provide Lockheed with stable business from trusted customers. This contract in particular extends until 2028. For context, Lockheed generated $10.9 billion in sales from the space segment in 2019, comprising 18% of its total consolidated net sales.

Healthy balance sheet

Space has its prospects, but Lockheed needs to prove it can grow its top and bottom lines during a period of tightened spending. The U.S. government isn't Lockheed's only customer but it did comprise over 70% of 2019 sales, with U.S. allies in Asia Pacific and Europe accounting for 10% each and the Middle East making up 7%. Aside from being the market leader in several key defense categories, Lockheed's prime advantage over its competitors is its balance sheet. 

LMT Financial Debt to Equity (Quarterly) data by YCharts

Lockheed sports a net debt position below $10 billion and the lowest debt to equity ratio of just 0.12. Its low debt and low leverage position it to take on more debt if needed to capitalize on growth, as well as providing a margin of safety to navigate challenges.

Stable and growing dividend

A strong balance sheet forms the foundation of an excellent dividend stock. 2021 will mark the 19th consecutive year that Lockheed has increased its annualized dividend. At $10.40 per share per year, its dividend has increased an astounding 2,300% since 2002. Backed by low debt, tons of free cash flow (FCF) and a payout ratio of just 45%, Lockheed's 3.1% dividend yield is one of the safer and more attractive industrial stock dividends on the market today.

A well-rounded buy right now

Dividend and value investors alike will find Lockheed's risk/reward profile attractive. Trading at a below-market average P/E ratio of just 15 with low debt, low leverage, and stable earnings, the only real negative is Lockheed's uncertain growth rate. But with two to three years of revenue in its backlog, the company makes up for its lack of revenue growth with reliability.

Lockheed isn't the flashiest company, nor is it trying to be. Instead, it's focused on maintaining a healthy balance sheet and generating tons of FCF that can then be used to grow its dividend. If that's an investment thesis you can get behind, then you may want to consider picking up a few shares right now.

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