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Are Gurus Divided About Defense Prospects?

The Sequester, a policy to control budget allocations in the US, affected many defense contractors through 2013. For some, the spending cuts meant a big blow to projected performance. For others, it offered an opportunity to take buy-out some competitors. On whichever side of the equation Northrop Gumman (NOC) and General Dynamics (GD) were, these are two companies that survived the policy and continue to offer rewards to shareholders.

Unmanned Vehicles and Top-Trading

Recent news highlights Northrop Grumman's new contract with the Department of Defense to develop and improve NAVY combat system trainers. The contract is worth $33 million and will focus on enhancing realism, reducing costs and facilitating operability. The news was adverted by the market, and the company reached a new trading lifetime high last March 5.

Northrop Grumman's core segments span across the Air Force, space and cyber security. Most importantly, the company has been able to curb budget cuts given the priority placed upon its programs. However, backlog orders have suffered due to The Sequester. Nonetheless, the firm's focus on superior program performance, effective cash deployment and portfolio alignment kept it well positioned.

The maturing of the Global Hawk program has given Northrop Grumman the opportunity to continue developing other unmanned programs. Products like de NATO AGS and Fire Scout will allow the company to expand geographically. Such programs are all the more attractive to potential buyers due to the great focus placed by developers upon operational performance, affordability and cost competitiveness.

The balance sheet for Northrop Grumman has stabilized in 2010 and shown no major changes. However, net income has seen some decline between 2009 and 2010. Trading at 14.8 times its trailing earnings, the stock carries a 23% discount to the industry average. Jean-Marie Evelliard has collected his winnings through a sale at the end of 2013, while Steven Cohen (Trades, Portfolio) made a strong bid on the firm.

Wide Portfolio and Strong Balance Sheet

General Dynamics is most known for developing the F-16 fighter aircraft, owning the producing rights for the M1 Abraham tank and commercial airplane brand Gulfstream. Nonetheless, the company is much more than that and divided its operations among four segments: information systems & technology, combat systems, marine systems and aerospace. And current success is reflected in the latest dividend increment.

The aerospace and information systems & technology segments have pushed growth for General Dynamics during 2013. Additionally, strong order book, systematic cash deployment strategy and cost-curtailment measures augur a healthy 2014 and beyond. It is true that The Sequester remains in place, but at the same time the firm has avoided its negative impact. Hence, the company is expected to increase market share at the end of the day.

Production of nuclear submarines is a duopoly in which General Dynamics has a stake. With the intention of strengthening its market positioning, the company acquired Applied Physical Sciences Corp. in 2012. Additionally, the company has ignited a set of restructuring policies to adjust capacity at European facilities. Most importantly, the Gulfstream commercial airplane segment continues to experience backlog increments.

The most important characteristic for General Dynamics is the strength of its balance sheet. Cash flow continues to rise, and operating margins have jumped 10 points. James Barrow (Trades, Portfolio) quickly took notice of the potential rewards and converted himself into the largest shareholder through 2013. Trading at 15.8 times its trailing earnings, the stock carries an 18% discount to the industry average.

A Good Defense

There is no clear evidence that points to the end of The Sequester and its budget cuts. However, the US will never let it defenses down. That is why we should not expect cuts to affect high priority defense projects and top contractors. Although both companies are in a good standing, I prefer General Dynamics because its commercial planes offer a good back-up to strong defense segments.

Disclosure: Vanina Egea holds no position in any of the mentioned stocks.

This article first appeared on GuruFocus.