Why Citi Downgraded These Defense Stocks

In a research note issued this Wednesday, Citi downgraded ratings of several popular defense stocks — General Dynamics Corporation (NYSE:GD), Northrop Grumman Corporation (NYSE:NOC), and Huntington Ingalls Industries Inc (NYSE:HII) — from buy to neutral.

Not expecting the defense sector as a whole to underperform, the research points towards valuations that, despite the defense-budget increase, appear to have priced-in the growth potential, which is expected to be lower than investors’ growth expectations due to changing operating environment—innovation-focused and cost efficient—that would affect margins.

Are they overvalued?

GD shares closed higher on Wednesday following the announcement of its quarterly dividend of $0.84 per share, up 10.5% from previously paid $0.76. Despite declining revenue, the company has consistently beaten earnings (EPS) expectations over the past two years, driven by material improvement in margins and share-buybacks to the tune of $5.2 billion in two years. GD shares are up 40% in a year.

The company’s forward yield is 1.75% after the dividend raise, paying out close to a comfortable 30% of its earnings. With that in mind, its strong balance sheet and earnings outlook make further dividend growth possible. However, at current prices, it appears fairly valued with an intrinsic value of $191 (market price: $192.4) and relative valuation that is in-line with the industry.

NOC, though, has an intrinsic value $281, compared to its latest closing price of $245.9 and the analysts’ median price target of $259. NOC demonstrated a stellar earnings and revenue track record in 2016, pushing the stock almost 28% higher over the past year.

Dividends of 1.5% appear safe due to a low payout ratio, EPS growth projection of nearly 23% in three years, and a strong balance sheet. The company’s relative valuation ratios are in-line with the industry – its trading in the fairly valued territory.

HII outperformed the other two with company shares up more than 60% in one year, despite a mixed earnings track record in 2016. Compared to the intrinsic value of $195, HII currently trades at $219.5. Its relative valuation is in-line with the industry and earnings growth outlook is weaker than GD and NOC – also subdued due to relatively low share buybacks by HII.

Based on fundamentals, the three companies appear fairly valued with HII appearing closest to being overvalued. Here’s an infographic comparison between the three companies: GD vs NOC vs HII.