The combination of a bull market in the U.S. and a reprioritization of worldwide defense spending, punctuated by the Russian invasion of Ukraine and the conflict between Israel and Hamas-led Palestinian militant groups, has translated to strong performance for defense stocks since late last year.
One diversified example is the iShares U.S. Aerospace & Defense ETF (ITA). It’s up 3% year to date and 19% since the October 7, 2023, attack on Israel.
The Invesco Aerospace & Defense ETF (PPA) is doing slightly better. It’s up 9% YTD and 21% since the October 7 attack.
Given the rapidly evolving global threat landscape, we are likely closer to the beginning of this trend than the end.
And while the diversified approach to investing in defense is an option, there are many examples of individual defense stocks that have the potential to outpace diversified ETFs.
One example is Leonardo DRS (DRS), a small-cap defense stock with a market cap just under $6 billion.
Leonardo is a prime contractor and strategic subcontractor that provides technologies and services spanning land, air, sea, space and cyber arenas.
The company is 73% owned by the Italian parent company Leonardo SpA (which is 30% owned by the Italian government), meaning the public float is pretty small here (27%). That may be a turnoff for some, but it also means DRS tends to be a stable stock and the potential for better liquidity could be an upside catalyst.
Leonardo’s customer base includes all branches of the U.S. military (Navy is 40% of revenue) as well as other contractors and allied governments and militaries.
Its two segments/key areas of technology include Advanced Sensing & Computing (ASC) and Integrated Mission Systems (IMS), which includes electric power and propulsion.
The company’s legacy solutions, including sensing and hardware solutions for ground systems, tanks and armored vehicles, generate consistent, high-margin revenue and remain in high demand (the 2024 President’s Budget request included $13.9 billion for ground systems, a 10% increase over 2023).
Then there are newer projects, like electric power for the Columbia-class nuclear submarine made by General Dynamics Electric Boat. Leonardo makes the main propulsion magnet motor and drive component, among other parts.
On the company’s Q4 earnings conference call (held yesterday morning), management talked about the huge potential in electric power and propulsion, and how alternative technologies are “inadequate in their ability to scale and power requirements needed for the future.”
This confidence, and the potential to go after other emerging opportunities in the IMS business, is why the company just announced a new facility in South Carolina.
This facility will be initially focused on Columbia Class production (expected to be occupied by 2026) while other electric power and propulsion business represents upside.
As a defense company, Leonardo’s growth isn’t insane. The company just capped off a year when revenue grew by 4.9% (to $2.8 billion) and EPS came in at $0.73.
But the work Leonardo is doing with General Dynamics/Electric Boat is just getting started. And the company is a potential acquirer of tuck-in businesses as well. This, and the South Carolina expansion, is why management says Leonardo isn’t ready to start paying a dividend yet. There are just too many other attractive options for cash.
Turning to guidance for 2024, management said we should look for 4% to 7% revenue growth ($2.95 - $3.03 billion), which straddles consensus estimates. EPS should be in the range of $0.74 to $0.82 (consensus is $0.83, suggesting some conservatism in guidance).
Again, not snap your head back type growth. But steady and solid, and with considerable upside potential.
This is what the chart looks like.
DRS corrected with the market in the first half of 2022 then spent the second half regrouping in the 9 – 12 range before a late-year rally. Shares continued their upward trajectory through 2023 (albeit with a few pauses here and there), ultimately closing out last year at around 20.
The 20 to 21 price area served as a zone of resistance dating back to October, but shares broke through that zone following a positive reaction to their latest earnings report.
You can learn more about Leonardo DRS, and the other exciting stocks I’m following, by grabbing a subscription to Cabot Early Opportunities here.
