Which Defense Contractor Is a Better Buy Today?

Looking for a great investment? One way to make sure you've picked the right stock is to compare it to a strong peer using a series of cold, objective financial results and other key statistics. With that in mind, we'll be taking a closer look today at two major defense contractors, Boeing (NYS: BA) and Northrop Grumman (NYS: NOC) .

Both companies will go head-to-head in several battles. The winner will be the one with the most cumulative victories through contests of valuation, earnings quality, and dividend sustainability. We'll also examine analyst optimism toward each stock, and take a closer look at each company's key initiatives, to see what sort of growth the market's top minds may see in the years ahead.

In this corner...
This isn't as straightforward as it may seem, due to Boeing's huge commercial aircraft division. Northrop derived 91% of its revenue from defense spending last year; Boeing only earned 47% of its revenue from the government.

However, Northrop has been arguably the best pure play in the sector, as it's the only company to improve its earnings -- Lockheed Martin (NYS: LMT) and General Dynamics (NYS: GD) both have seen their earnings decline over the last three years. This may be due to the company's production of successful unmanned aerial vehicles, or UAVs, but it's just as likely that Northrop's success comes from its diverse military construction capabilities for land, sea, and air.

Boeing's no slouch on defense, either. Its defense segment alone bested Lockheed's cumulative growth in the first quarter. If you thought Boeing would be insulated from the potential sequestration (a result of last summer's debt showdown) that threatens to torpedo defense stocks, think again. Should sequestration be activated, Boeing's biggest military contract would get cut in half.

Boeing's commercial aircraft division represents a huge potential advantage over Northrop. And I do mean huge -- Boeing alone accounts for nearly 2% of American exports. The 787 may have gotten all the attention in recent years, but very public delays have forced the company to lead with an updated and more fuel-efficient 737. United Continental (NYS: UAL) has been a big buyer, with major orders of both the 787 and the new 737 MAX. Airlines may need Boeing over the long run, as rising fuel costs are turning the screws on an industry that's long struggled with profitability.

Will the defense standout win the day, or is Boeing's diversification enough to put it over the top? Let's go down to ringside and we'll soon find out.

Valuation battle
We use many different numbers and ratios when talking about the value of a stock. We'll check each company's current P/E and its average P/E over the last five years. We'll also check current and five-year average price-to-free-cash-flow ratios. Earnings can be gamed with a number of different accounting tricks, but free cash flow is harder to manipulate, making it a favored metric here at the Fool.

The difference between a stock's ratio today and its five-year average will be more important than the numbers themselves. Ratios much lower than their averages may have more room to grow back to that middle ground. Ratios much higher than average may be at risk of declines.

For the tiebreaker, we'll check one lesser-used ratio: enterprise value to EBITDA, which my Foolish colleague Matt Koppenheffer fully explains here. A smaller number is better when it comes to well-established companies, as it may point toward stronger future growth.

Source: Wolfram Alpha and YCharts. Winners in bold.

Northrop squeaks through with a victory, helped by a mouthwateringly low P/E ratio. Northrop's been cheap for so long that a single-digit P/E no longer means much, but by hewing closer to its five-year averages and with a bargain basement tiebreaker EV/EBITDA, it takes this contest.

Earnings quality battle
A company can be cheaply valued without being a good value. To balance out our valuation fight, let's look at a few key earnings statistics for each company. We'll look at each company's operating and net margins, five-year annualized rates of earnings growth, and streaks of both profitable years and improving profitability. A company with no momentum today is less likely to become a superstar later -- it has happened before, but not often.

Sources: Yahoo! Finance and Wolfram Alpha. Winners in bold.

Northrop takes the earnings crown! Despite having its streak of profitability broken by the recession, Northrop's rebounded nicely to maintain better long-term growth. Will its superior margins help it win the dividend battle ahead?

Dividend battle
Let's see how strong and stable each company's dividend payments are. We'll examine yield and two payout ratios, both the standard net-income payout ratio and the free cash flow payout ratio. We'll also examine each company's five-year annualized dividend growth rate and its streak of uninterrupted payments.

Those payout ratios are important, particularly the free cash flow payout ratio. Companies that pay out more than they take in can rarely sustain such practices for long.

Sources: Morningstar and Dividata. Winners in bold.

Northrop's margins do indeed appear to offer more sustainable dividends at its current payout levels. Northrop could easily support a decision by management to reward shareholders with increased payouts.

Battle for the future
How do the world's most engaged market participants view these companies? Let's see what Wall Street's analysts expect, and what our Motley Fool CAPS community thinks.

Sources: Yahoo! Finance, Motley Fool CAPS.

Our CAPS players seem to prefer Northrop's chances, but you shouldn't ignore the widespread bullish analyst sentiment behind Boeing. Boeing's certainly got Wall Street on its side -- its commercial aircraft operations may well carry it past reduced government spending next year. However, Northrop's swept the rest of this contest, and comes out on top in the end.

These two dividend stalwarts might have to reduce their payouts if budget cuts become severe enough. Defend yourself against the government's heavy hand with three dividend-paying Dow stocks for all seasons. They're all described in full in the Fool's latest free report, so click here to find out more at no cost.

The article Which Defense Contractor Is a Better Buy Today? originally appeared on Fool.com.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter @TMFBiggles for more news and insights.The Motley Fool owns shares of Lockheed Martin, General Dynamics, and Northrop Grumman. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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