Credit Suisse: Pension Income, Potential Budget Slowdown Neutralize Defense Manufacturers

Defense hardware stocks have surged above the S&P 500 for six consecutive years, but Credit Suisse thinks they’re about to run aground.

The Ratings

Analyst Robert Spingarn downgraded the sector from bullish to neutral and cut the following price targets:

• BWX Technologies Inc BWXT from $72 to $64 with a Neutral rating;
• General Dynamics Corporation GD from $263 to $234 with an Outperform rating;
• Harris Corporation HRS from $189 to $175 with an Outperform rating;
• Huntington Ingalls Industries Inc HII from $301 to $259 with an Outperform rating;
• L3 Technologies Inc LLL from $244 to $218 with an Outperform rating;
• Lockheed Martin Corporation LMT from $380 to $335 with a Neutral rating;
• Northrop Grumman Corporation NOC from $342 to $326 with a Neutral rating; and
• Raytheon Company RTN from $250 to $219.

Spingarn also downgraded Raytheon from Outperform to Neutral. (See the analyst's track record here.) 

The Thesis

The 21.6x multiple for defense hardware stocks is more than two standard deviations over the 34-year average of 12.7x. Credit Suisse expects a reversion toward the mean as pension income and budget growth peak and subsequently decline.

Spingarn’s thesis reflects the possibility of rising interest rates diverting investment from the space; the potential for a post-midterm-election budget sequester; and the likelihood for segment margins to flatten.

“There is now relatively less upside in this previously hot sector, as we expect the market to look further to the right to a normalizing outlook and become increasingly skeptical of valuations that place a multiple on pension income,” the analyst said in a Tuesday note. 

Nonetheless, Springarn anticipates positive long-term performance in the sector given program visibility and international exposure. General Dynamics, Huntington Ingalls, Harris and L3 are particularly pegged as outperformers.

Price Action

At the time of publication, Raytheon traded down 2.42 percent, Northrop Grumman 2.1 percent, Harris 2.1 percent, Lockheed Martin 1.8 percent, L3 1 percent, Huntington Ingalls 0.9 percent, BWX 0.7 percent and General Dynamics 0.5 percent. 

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Photo by the U.S. Navy via Wikimedia.