By Al Root

Disruption has come to the military-industrial complex. Defense stocks have lost the first battle, but they can still win the war.

The past year has been a trying one for defense companies like Northrop Grumman, Lockheed Martin, and General Dynamics as they fight disruption on two fronts. In the first, the way wars are fought has changed, from the Russia-Ukraine conflict, where cheap drones have been weaponized to make up for lack of manpower and equipment, to the Middle East, where unmanned aerial vehicles have become essential combat tools for offensive purposes, reconnaissance, and targeting.

It's a world where the $13 billion U.S.S. Gerald R. Ford, a nuclear-powered aircraft carrier that took eight years to build, can be threatened by hypersonic missiles or autonomous subs and torpedoes costing mere millions. When cheap technology can make any weapon obsolete, long development times and billion-dollar price tags feel like luxuries no one can afford.

If that weren't enough, defense companies are fighting on the home front, too. Every new administration brings change, but the early days of the Trump administration have been more chaotic than usual. Department of Defense Secretary Pete Hegseth was barely confirmed by the Senate -- Vice President JD Vance had to cast the deciding vote -- and President Donald Trump fired Chairman of the Joint Chiefs of Staff C.Q. Brown, an unusual step for an incoming president.

With leadership in turmoil -- and a series of Elon Musk tweets arguing that new artificial-intelligence enhanced technology from upstarts such as Palantir Technologies and Anduril Industries should replace long-established military programs -- it's little wonder that shares of Lockheed, Northrop, General Dynamics, and L3Harris Technologies have slumped 10% on average since the election, while shedding about $25 billion in market value. On the surface, the defense sector looks like could be fighting a rear-guard action for years to come.

But looks can be deceiving. Disruptive change can't always be accomplished by existing players, and traditional defense contractors have a history of being able to deliver new weapons when needed. That should be the case even as the military shifts toward cheaper, smarter, AI-enhanced weaponry. At the same time, there will still be a need for more-traditional jets, boats, tanks, and missile systems that only the likes of Northrop and Lockheed can provide.

With shares of defense prime contractors' stocks trading lower valuations than they did when the 2011 Budget Control Act threatened to slash military spending, now seems like a good time to bet that their stocks won't fade away but emerge stronger from the skirmish.

"There's no Amazon and Barnes & Noble analogy," says Capital Alpha Partners analyst Byron Callan of the clash between disrupters and traditional companies. "It's Amazon and Walmart."

War always changes. Arrows give way to bullets, wood to iron, propellers to jets. Every new discovery is then iterated on and perfected, until new technologies emerge and the process starts again. That is true now more than ever. Battlefields around the world have become laboratories for new weapons and strategies. In early May, Ukraine claimed to have shot down two Russian fighter jets with seaborne drones. The U.S. has been using its Maven AI system to hunt for Houthi targets, which had resorted to shooting down drones and missiles from Yemen with RTX-made Patriot missiles. Patriots are effective, but firing the million-dollar missiles at cheap drones is like exchanging a queen for a pawn.

When the enemy has cheap weapons at their disposal, bringing down costs matters -- a lot. Much of the current system is based on "cost-plus contracts," essentially agreements that provide weapons producers with a guaranteed profit margin. There's a logic to the system. There's no commercial market for jet fighters, for example, and few alternatives for the Pentagon if it isn't happy with one price. It ensures the military has what it needs, usually when it needs it.

The potential problem, though, is obvious: Cost-plus provides a tacit incentive to inflate costs throughout the supply chain. A "hard bid" system, where companies offer a price and then deliver the goods, would make more sense. It might not work for aircraft carriers or fighter jets, but it can work for drones and munitions.

The Pentagon is aware of the need to balance cost and performance. The U.S. military already uses dozens of unmanned systems on land, sea, and air, with more on the way. Drone advancements are why the Army killed the more expensive Future Attack Reconnaissance Aircraft program in 2024. Trump also endorsed unmanned collaborative combat aircraft, or CCAs, where one pilot might command 10 pilotless planes, while simultaneously awarding a sixth-generation manned fighter-jet program to Boeing.

Defense contractors have proven that they can act quickly and cheaply when pressed. During the first Gulf War, traditional defense contractors and the U.S. military designed, tested, and deployed a bunker buster called the GBU-28 -- capable of destroying Saddam Hussein's facilities, buried 150 feet underground -- in less than a month. It helped end the war. That is the speed at which things can happen when requirements and motivations align.

The ability to align, however, has been lacking in the Trump administration. The president has fired inspectors general, who are charged with ensuring that the government gets value for its money, and infighting has led to threats of polygraph tests for senior officials suspected of leaking. The Pentagon declined to comment on the reports.

Trump's goal, however, is clear. He wants a stronger, more efficient military apparatus that can rapidly deploy new technology, ensuring America's military dominance in the face of growing threats from China and elsewhere. Barring an outbreak of world peace, the U.S. will be spending roughly 3% of gross domestic product on national security for years to come. Trump's initial request for fiscal-year 2026 is just north of $1 trillion, up 13% from 2025. The $113 billion year-over-year increase includes money to expand shipbuilding, fund the F-47 next-generation fighter jet, modernize America's nuclear arsenal, and develop Trump's "Golden Dome" missile defense shield. It's only a proposal, but it's a bullish sign.

The devil will, of course, be in the details. For investors, the risk is that more money goes to start-ups and less to the big defense companies. One to watch is privately held Anduril, which was founded in 2017 to do to defense prime contractors what SpaceX did to the space launch industry. Its goal is to leverage commercially available technology, combined with software and AI, to build lower-cost, more-capable products faster, says co-founder and executive board chairman Trae Stephens.

Anduril is still small but growing. Contract awards total some $4 billion. It's also worth some $30 billion in private markets. L3Harris has a market value of about $41 billion and a current backlog north of $33 billion. Still, says Callan, Anduril is "placing a lot of different bets across a lot of different market segments" -- and that's a departure from other start-ups.

Anduril isn't the only defense upstart worth watching. So are privately held Mach Industries, which works on low-cost strike drones, and Shield AI, which works on AI for military hardware. Publicly traded AeroVironment, Karman Holdings, and Kratos Defense & Security Solutions are small-cap stocks that are working on smart munitions and drone technology. The presence of these upstarts could push the legacy defense companies to move faster and work more cheaply. "It's fantastic to have new competition," says AeroDynamic Advisory managing director Richard Aboulafia.

While investors can't buy Anduril, they can buy AeroVironment, which makes Switchblade loitering munitions -- remote-controlled kamikaze drones with a camera -- and Puma reconnaissance drones. Once a hot stock, its shares have been hit hard by America's volatile policy toward Ukraine. In its fiscal-year 2024, Ukraine accounted for 38% of total sales, about $274 million. That has fallen off, creating an air pocket for sales -- and for the stock. Shares are down 29% since the November election.

There is more growth ahead, though. The company just completed a merger with autonomous systems provider BlueHalo. Combined sales in fiscal-year 2026 should be $2 billion, says Jefferies analyst Greg Konrad, while earnings before interest, taxes, depreciation, and amortization should be about $350 million. That Ebitda justifies a 25 times multiple or a share price of $190, he says, up 22% from a recent $156. "Everything that AeroVironment sees today, from its backlog to the pipeline to opportunities with BlueHalo, supports that [it] has never been better positioned than today," Konrad says.

Among traditional defense prime contractors, L3Harris Technologies looks like a winning bet thanks to the diversification of its business. Its Integrated Missions Systems unit makes radar warning systems for jet fighters and avionics for commercial aircraft, among other products, while its Space & Airborne Systems group builds satellites. A communications business sells products such as radios for the Army, and its acquisition of Aerojet Rocketdyne in July 2023 gave L3Harris a fourth business, making rocket engines.

"L3Harris is not highly concentrated [on] one program and is therefore well positioned to benefit from a growing defense budget, but is also better protected from budget changes," says Goldman Sachs analyst Noah Poponak, who has a Buy rating and $283 price target for the stock, up about 31% from a recent $216.

Northrop looks like another winner. Perhaps best known for its stealth bomber, Northrop is diversified across aerospace, missile defense, nuclear weapons, surveillance, unmanned systems, and space. It's everywhere. It could also get a bump if it can win the contract over Boeing for the Navy's Next Generation Air Defense, or NAGD, program, which is set to design and build the Navy's six-generation manned fighter jet.

While Northrop shares trade at 19 times 2025 earnings estimates, a 12% premium to Lockheed Martin, the premium is warranted, says Morgan Stanley analyst Kristine Liwag. Its earnings are expected to grow at about 9% a year for the next three years, two percentage points faster than Lockheed. Liwag calls Northrop her "top pick" in the sector, while her price target of $570 a share suggests 22% upside from a recent $467.

Lockheed is in a tougher spot. A Barron's pick in June 2024, things were going relatively well into late 2024 until a Nov. 24 tweet from Musk deriding manned fighter jets created a hurricane-force headwind. Lockheed shares have fallen 14% since then. It now trades at 15.5 times 2026 earnings, a 15% discount to the S&P 500 index, even larger than the one Lockheed had from 2011 to 2015, when military spending was declining and the stock traded at a 10% discount to the market.

Musk's tweet creates a problem for Lockheed's F-35 fighter jet, the $2 trillion defense program that accounts for more than a quarter of the company's sales. At the turn of the century, the Pentagon wanted one plane for the Air Force, Navy, and Marines. They got the F-35, a $100 million machine that costs hundreds of millions more to maintain over its useful life. Part of the reason it costs that much is because it does a lot -- combining stealth and advanced sensors for surveillance and air-to-air and air-to-surface combat. It can even take off and land vertically. It still represents American air dominance and will be in service for decades to come, even if Musk wants to kill it.

For now, though, tension with the administration will probably keep a lid on the stock, says Vertical Research Partners analyst Rob Stallard. "Lockheed is probably at an appropriate multiple," he says. "It's fairly valued." He rates shares Hold and has a $505 price target for the stock, up 8% from a recent $467.

Beaten-down Booz Allen Hamilton Holding, however, looks downright cheap. The stock, down 36% since November's election, has been hammered ever since the Department of Government Efficiency took the scalpel to government contracts. That is particularly bad news for Booz, which gets about three-quarters of its business from national security.

Booz, however, is much more than a consultant. After 9/11, it built the system that American security agencies use to share information. In December, Booz partnered with Palantir to bring AI-infused software and hardware to U.S. warfighters. The combination of "AI" and "national defense" is a big reason that Palantir trades for 163 times estimated 2026 earnings. Booz trades for about 16.6 times. Headline risk remains, but earnings are expected to grow 11% for the next couple of years, a little faster than the S&P 500, and its valuation is the lowest over the past five years.

War may be changing, but defense companies like Booz will always find a way to profit from it.

Write to Al Root at allen.root@dowjones.com

This content was created by Barron's, which is operated by Dow Jones & Co. Barron's is published independently from Dow Jones Newswires and The Wall Street Journal.

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May 09, 2025 01:00 ET (05:00 GMT)

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