Defense stocks have been on a tear in recent months, with many names hitting new all-time highs. The ongoing highly volatile geopolitical environment is primarily driving this surge. This includes the ongoing war in Ukraine and the increasingly unstable situation in the Middle East, particularly the conflict between Israel and Hamas, along with the involvement of other parties such as Hezbollah and Iran.
In response to this landscape, defense budgets are soaring globally, translating into growing order backlogs and boosting revenues for companies in the sector.
While this rally in defense stocks seems justified, given the soaring budgets, some defense stocks appear to have gotten ahead of themselves, now trading at hefty valuations. As a result, the downside potential is growing for some names in the space.
These three defense stocks to sell have rich valuations that could soon lead to significant declines. Investors may want to consider selling these stocks before such downside materializes.
Northrop Grumman (NOC)
First on the list is Northrop Grumman (NYSE:NOC), a leading defense contractor known for products like the B-21 Raider bomber, Global Hawk drones, and advanced radar systems for the F-35 fighter jet. The company is capitalizing on the turbulent geopolitical environment, as reflected in its strong Q2 results.
In its latest quarterly report, the company posted a strong performance, with revenues climbing 7% year-over-year to $10.2 billion. Earnings per share also saw a notable jump, rising 19% to $6.36. This impressive growth was fueled by robust sales across all divisions, notably Aeronautics Systems, which reported a 14% revenue increase, and Defense Systems, which grew by 7%.
Further, the company’s total order backlog reached an all-time high of $83.1 billion, including $38.4 billion in funded contracts, providing excellent cash flow visibility. This substantial backlog underscores the recent surge in orders, positioning Northrop for sustained top and bottom-line growth in the coming years.
Despite these encouraging numbers, Northrop Grumman’s stock rallied 16% over the past month, pushing its valuation to about 20x earnings. At these levels, the stock may be pricing in much of the good news, leaving it vulnerable to downside potential if defense industry tailwinds weaken in the medium term. Thus, you may want to consider selling before such risks materialize.
TransDigm Group (TDG)
Next up, we have TransDigm Group (NYSE:TDG), a leading manufacturer of highly engineered aerospace components, including aircraft systems, parts, and subsystems. The company’s products, such as specialized pumps, valves, actuators, and safety systems, are critical to commercial and military aircraft. TransDigm benefits significantly from the current geopolitical environment, as rising defense spending worldwide drives demand for its military-related products.
Notably, the company’s strong market position is underscored by its ability to maintain a robust pricing power due to its monopoly-like control over many of its highly specialized products. This favorable backdrop was again reflected in its fiscal Q3 results, where sales grew by 17.3% year-over-year to $2.05 billion, including organic sales growth of 14.6%. Adjusted net income also increased 25.8% to $521 million, or $9 per share, showcasing the company’s strong profitability in this environment.
Despite its impressive results, TransDigm’s stock seems to trade at an extremely expensive valuation. The company’s robust moat, built on its specialized products and pricing power, may justify a premium multiple for the stock. However, at 37x this year’s and 31x next year’s expected earnings per share, TransDigm’s valuation could imply downside potential if the stock undergoes a valuation compression to more modest levels.
Heico Corporation (HEI)
Lastly, investors should exercise caution with Heico Corporation (NYSE:HEI), an aerospace and defense company specializing in designing and manufacturing high-performance components and systems for commercial and military aviation. Heico’s products include aircraft replacement parts, avionics, and electronic systems. Therefore, like TransDigm, Heico benefits from the unstable geopolitical environment, as increased defense budgets drive higher demand for its military-related components and systems.
Heico’s essential position in the defense sector is bolstered by its role as a key supplier of critical and often proprietary components, which are crucial for maintaining operational readiness and performance. Today’s favorable environment is evident in Heico’s recent Q2 results. Net sales surged 39% year-over-year to a record $955.4 million, while operating income rose 33% to $209.2 million. Despite a slight dip in operating margin to 21.9%, these results highlight the company’s strong performance amidst rising defense spending.
However, following a 38% rally in its stock over the past year, Heico’s shares now appear overly rich, trading at around 66x this year’s expected EPS. Even with the prospect of enduring double-digit EPS growth, this multiple could imply notable downside potential if the current industry tailwinds were to diminish.
On the date of publication, Nikolaos Sismanis did not hold (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.
On the date of publication, the responsible editor did not have (either directly or indirectly) any positions in the securities mentioned in this article.