Northrop Grumman Corporation: How Defense Budget Will Fare In 2014?

Defense stocks have performed like champions so far this year with the group up 52 percent, which is well ahead of the 38 percent average return for commercial aerospace stocks and more than the S&P's 25 percent return.

Investors have forgiven a lack of top-line growth and instead focused on margin and cash flow, both of which appear to be holding up remarkably well despite sales pressure.

Entering 2013, the defense sequester reduction was supposed to be $54.7 billion to the fiscal 2013 budget. When all was said and done, the actual cut was $31 billion (through the passage of the ATRA, a revision in OMB calculation methods, and by rescinding prior year budgeted funds).

For fiscal 2014, the Ryan-Murray budget conference will similarly lessen the blow from sequestration (much like the ATRA legislation in early 2013).

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Deutsche Bank analyst Myles Walton said the budget deal creates some foundational stability for both fiscal 2014 and fiscal 2015. The fiscal 2014 budget remains under a continuing resolution that is tied to the sequestered levels of fiscal 2013 ($497 billion top-line ex OCO).

However, the above level is still about $19 billion above the sequester-required base budget funding level of $478 billion. The budget conference committee chaired by Congressman Ryan and Senator Murray found a compromise that at least put the fiscal 2014 on equal footing with fiscal 2013 and similarly holds the line in 2015.

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Based on Walton's bottom-up revenue estimates, consensus sales estimates for large defense contractors appear to be inclusive of no major relief from sequestration over the next couple of years.

Given the relatively small size of the mini-deal, the impact to sales should be negligible for 2014 and about low-single-digit upside to 2015 estimates. Meanwhile, the contractors are not standing still in the face of budgetary pressure and continue to find ways to keep costs down well in advance of revenue declines, which has up till now translated into margin expansion and growth in cash per share.

Defense companies on average trade at just over 13 times forward EPS, which is 3 points higher than the 10 times the group traded at the start of 2013 and 4 turns higher versus beginning of 2012. Relative to the S&P 500, the defense group trades at just a 12 percent discount, versus 19 percent discount at the start of 2013 and a 22 percent discount at the beginning of 2012.

Walton noted that the relatively strong recovery in defense multiples, coupled with more modest EPS growth, means investors should remain more selective in the group.

In terms of particular stocks, Huntington Ingalls Industries Inc (NYSE:HII) and Northrop Grumman Corporation (NYSE:NOC) are the best performers gaining 100 percent and 68 percent, respectively, this year. Relatively, General Dynamics (NYSE:GD) is the "worst" rising 31 percent. Limiting downside among defense stocks are the plethora of options available to companies thanks to low gross debt levels and strong free cash flow, as well as excellent cost control (driving positive cumulative catch up adjustments), and below-market valuation.