Tuesday, September 30, 2014

Are Defense Stocks Good Defensive Stocks?

When the economy and the market starts heading south, many investors start buying dividend growth stocks. They have long been considered a defensive position in turbulent times. Given these investors defensive stance, one might ask how about some real defense stocks, as in the Aerospace and Defense industry.

With a steady flow of government money, defense stocks have long been considered a safe haven when the economy slows down and the market begins to sputter. However, with so many countries around the world, including the U.S., facing huge budget deficits, defense spending is where many politicians are looking for significant spending cuts.

As a result of the 2011 Budget Control Act, which took effect in January 2013, the U.S. Department of Defense must reduce spending by a total of $1.1 trillion over the eight-year period from 2013 to 2021. To this point, the industry has emerged relatively unscathed. In the near-term things might actually improve with the defense sector experiencing a rebound as a result of the U.S. military involvement in Iraq. Such actions could well affect the fiscal 2015 defense budget

Below are several defense stocks to consider and how they might be affected in the future:

Lockheed Martin Corp. (LMT)
This company, the world's largest military weapons manufacturer, is also a significant supplier to NASA and other non-defense government agencies. With about 93% of its revenues from global defense sales, LMT will be hard-pressed to escape unblemished when the budgetary ax falls. Anticipating upcoming cuts, the company has systematically reduced its workforce head count to 113,000 from 146,000 in 2008.

The stock boasts a yield of 3.3% after its recent dividend increase of 13% - its 12th consecutive double-digit dividend increase. I currently rate LMT as a 4-Star Strong stock and it is trading at a discount to my calculated fair value. You can read the full analysis of LMT here.

Northrop Grumman Corp. (NOC)
This company is the world's third largest producer of military arms and equipment, with about 90% of its revenue from defense, and also has a large government IT services business. To the company's credit it has streamlined its business to focus on more profitable contracts such as command, control, communications, computers, intelligence, surveillance, and reconnaissance, or C4ISR; cybersecurity; unmanned aerial systems; manned aircraft; and services and logistics.

NOC's lower yield of 2.3% reflects its strong balance sheet, low free cash flow payout (35%) and low debt to capital (36%). The company has aggressively bought back its stock over the last decade, while its dividend increases have averaged 11.7% from 2004 to 2013.

Raytheon Co. (RTN)
Raytheon, the world's sixth largest military contractor, specializes in making high-tech missiles, advanced radar systems and sensors, defense electronics, and missile-defense systems. As a result of its non-platform-centric focus, RTN is one of the best-positioned companies among the large-cap defense players. Its diversified military products and GaN technology have helped the company gain a mixture a small and big defense contracts. Approximately 80 countries purchase the company's products.

Yielding about 2.6%, RTN has an excellent balance sheet, low free cash flow payout (30%) and good debt to capital (29%). However, the stock is currently trading above my calculated fair value of $67.68.

General Dynamics Corp (GD)
General Dynamics is the world's fourth largest military contractor and also one of the world's biggest makers of corporate jets. GD, with its diversified offerings, is also in a good position to survive defense spending cuts. The company's Aerospace business continues to enjoy a significant backlog for large-cabin aircraft, and should remain strong over the next several years. There is an opportunity to see margins expand as production becomes increasingly efficient.

GD's strong balance sheet, low free cash flow payout (29%) and low debt to capital (23%) make it an appealing stock. However, its low yield of 2.1% and premium price to my calculated fair value will keep me from adding to my position in the near-term.

Aerospace and defense companies that do a lot of government work usually enjoy long contracts and are in a good position to weather economic downturns. However, to varying degrees, each of the above companies also is engaged in non-government commercial business that could be adversely affected by the next economic downturn. There is certainly a spot for defense stocks in my dividend growth portfolio, but I will patiently wait for the right time and entry point.

Full Disclosure: Long LMT, RTN, GD in my Dividend Growth Portfolio. See a list of all my dividend growth holdings here.

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