A Citigroup Inc. (NYSE:C) report released Sunday points to defense as an industry likely to outperform in the coming months. The report, entitled “Why defense stocks are heading higher,” looks at Federal budget expectations, as well as fears surrounding it, along with other factors. The holistic analysis suggests that defense stocks are cheap, and now is the time to buy.

Defense stocks

Jason Gursky, the analyst who authored the report, decided to change the methodology used to evaluate defense companies in this report. A previous analysis was based on a P/E multiple with a 15% discount to the wider market. That model was based on information from previous defense spending drops. It failed to take into account key changes in the structure of the industry, however.

Leverage, cash, pensions and margins

The changes in the defense industry unaccounted for by the previous model include changes in leverage in the industry, unexpected resilience in margins in the industry and better than expected trends on pensions due to be paid by the company.

The new valuation used by the Citigroup Inc. (NYSE:C) analysts is based on 8.9 times the company’s EBITDA. The previous valuation was closer to a 7.2 multiple. The new model, along with the dynamics surrounding the defense budget, means that now is the time to buy into the defense industry, according to Gursky.

In terms of trading around the budget, Gursky believes that prices will head lower as investors worry about cuts in military spending. Defense stocks should head higher once the budget is actually announced, should the Citigroup prediction about the budget pan out. That prediction suggests that defense spending will increasingly be moved from personnel to hardware, meaning that even if the defense budget shrinks substantially, contractors will not be hit all that hard.

Everything in defense is a buy

Because of the new valuation methodology, price targets have gone up across the board in the defense industry. The big contractors studied in the Citigroup Inc. (NYSE:C) report are all rated as a Buy. The companies specifically studied include General Dynamics Corporation (NYSE:GD), Huntington Ingalls Industries Inc (NYSE:HII), Lockheed Martin Corporation (NYSE:LMT), Northrop Grumman Corporation (NYSE:NOC), and Raytheon Company (NYSE:RTN).

The optimism from Citigroup Inc. (NYSE:C) on the defense industry is almost unchecked, driven by the reevaluation of the entire industry’s worth. If the prediction about the budget comes true, defense investors might bring in solid returns in the coming months.