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3 Top Defense Stocks to Watch in September

Jason Hall, Rich Smith, and Travis Hoium, The Motley Fool

Defense stocks have been hot investments for more than five years, with many of the biggest defense contractors delivering more than double the S&P 500's total returns. And while a substantial portion of that return has been because of the tremendous profit growth in the industry, investors have also been willing to steadily pay a higher premium for defense stocks, paying up front for future profits. And at some point, the defense spending cycle will turn, and the outsize returns of the past decade could turn into underperformance. 

But that doesn't mean investors should avoid the entire sector; there are opportunities to be had. These Motley Fool contributors have identified two companies with substantial military and commercial opportunities in AeroVironment, Inc. (NASDAQ: AVAV) and Boeing Co. (NYSE: BA), as well as undervalued British defense giant BAE Systems PLC (ADR) (NASDAQOTH: BAESY) as defense stocks worth watching closely this month. 

Fighter jet cockpit.

Image source: Getty Images.

Taking to the skies

Travis Hoium (AeroVironment): One of the defense stocks I'm watching closely right now is AeroVironment, maker of small drones for the military and commercial applications. The company recently sold its electric charger business to Webasto Group for $32 million, allowing it to focus entirely on drone applications. 

In fiscal 2018, drone revenue rose 18% to $271 million and earnings from continuing operations jumped $0.32 to $0.95, showing the strength of the drone business today. Funded backlog also jumped from $70.9 million a year ago to $174.3 million at the end of the fiscal year. There's no question that increased military use of drones is helping AeroVironment's financial situation. 

What really excites me about AeroVironment is its potential in commercial drones, which could total $17 billion by 2024, according to Global Market Insights. There are a number of applications where AeroVironment can use military technology for commercial uses like agriculture, oil and gas exploration, and security. It's already testing products in the market, and over the next decade, this will be a business that could become a significant portion of sales, if market projections are correct. 

AeroVironment's stock isn't cheap at over 60 times trailing earnings, but in a market with the potential of drones, it's worth paying for an industry leader today. 

An old company wins a new day in carrier aviation

Rich Smith (Boeing): Shares of defense giant Boeing endured a rough five days last week, falling 3% through Friday -- but then, a miracle happened.

Against all odds, Boeing's offering won the Pentagon's MQ-25A "Stingray" competition, which at one point was designed to create a new stealthy attack drone for the U.S. Navy, but devolved into a competition to build unstealthy remote control aircraft to refuel piloted fighters instead. In so doing, Boeing beat out competing offerings from both Lockheed Martin (the No. 1 name in stealth) and General Atomics (the No. 1 name in drones), and outlasted Northrop Grumman (previously the No. 1 name in carrier drones) when Northrop withdrew from the competition.

Why does this make Boeing a defense stock to watch in September? Boeing's big win gives its defense division new life -- and arguably a commanding lead over Lockheed and Northrop in the naval aviation market, should the Navy choose to grow its drone fleet and later evolve it into the attack-drone air wing that was initially envisioned.

Combined with Boeing's already attractive valuation -- less than 16 times free cash flow for a stock growing at 15% (according to S&P Global Market Intelligence) and paying a 2% dividend yield, and I see every reason for Boeing stock to bounce this month.

A solid value in an expensive segment

Jason Hall (BAE Systems): While I agree with my colleagues that both Boeing and AeroVironment are worth a close look right now, they -- along with many of their defense peers -- have seen the market steadily pay higher and higher premium multiples over the past decade. 

BAESY PS Ratio (TTM) Chart

BAESY PS Ratio (TTM) data by YCharts.

BAE Systems, on the other hand, hasn't enjoyed as much of a run-up. That's in part because it's generated much lower operating margins than other defense contractors in recent years, so investors haven't been willing to pay as much of a premium. 

But looking forward, I think its lower multiple, along with a big $26 billion deal with Australia that should drive solid revenue and earnings growth over the next five to 10 years, makes it one of the few value stocks in defense today. 

At recent prices, BAE Systems trades for less than 1.1 times sales, barely more than half that of Boeing. Boeing is a bit cheaper on a trailing earnings basis, but looking at forward-earnings estimates, BAE is very fairly valued while actually being substantially cheaper than almost every defense stock on a trailing cash flow basis.

BAESY Price to Free Cash Flow (TTM) Chart

BAESY Price to Free Cash Flow (TTM) data by YCharts.

Boeing remains one of the best defense/aerospace combo stocks out there, while AeroVironment's long-term growth potential is tremendous. But investors shouldn't sleep on BAE Systems' potential as a surprisingly solid value. 

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Jason Hall has no position in any of the stocks mentioned. Rich Smith has no position in any of the stocks mentioned. Travis Hoium owns shares of AeroVironment. The Motley Fool recommends AeroVironment. The Motley Fool has a disclosure policy.