Unsustainable Government Spending A Major Blow To Defense Stocks

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Though Lockheed Martin (NYSE: LMT) and many other military contractors seem like compelling dividend plays, their businesses are based largely on unsustainable government spending. Income investors would do better by finding dividends from more companies like Johnson & Johnson which are not private-sector offshoots of discretionary government spending. Investors in aerospace firms should protect themselves by screening out firms with the most business from military contracts.

The Case for Shrinking Military Budgets

The United States will ultimately be forced to dramatically cut military spending much more than it already has, which means defense stocks like Lockheed see ever-larger cuts. Consider the following facts about US military spending:

The United States accounts for 44.4% of the world’s military spending. The United States economy is not large enough to justify such a share with a GDP accounting for 19.8% of the world total and a population that is only 4.47% of the total world population. Thus, on a per-income basis the United States could reduce military spending by 50% and still be in line with the rest of the world. Furthermore, on a per-capital basis the United States could reduce military spending by 90% while maintaining an average defense budget. Clearly, the United States has an oversized military budget in today’s world.

Furthermore, there is no geopolitical need for such bloated military spending. The Cold War is over and the war in Afghanistan remains an unnecessary, albeit declining burden. Pundits warn against pulling out sound the same as those who warned against the US withdrawal from Iraq or Vietnam.

Finally, military spending is terrible GDP stimulus. The “D” in GDP stands for “domestic,” a jurisdiction which is misses of multiplier effects felt by local economies host to troop deployments based overseas in countries like Japan, Germany, Italy, among others. Spending money on troops assigned inside the United States also makes for poor stimulus since many of these soldiers and their families live on-base, shop on-base in commissaries, and even buy gasoline on-base (procured from “budget surplus”). A fraction of this spending applied to other, less insular projects would result in a greater stimulus effect at lower cost.

Companies to Avoid

There are many notable stocks which profit for the outsized military budget of the United States. The following is a list of stocks in the aerospace industry which pay higher dividends than the 10-year treasury:

 

Ticker

Company

P/E

P/B

Dividend Yield

Payout Ratio

Total Debt/Equity

US Gov Revenue (2010)

LMT

Lockheed Martin

9.8

16.7

4.95%

              0.42

4.11

85%

(RTN)

Raytheon

8.92

1.98

4.03%

              0.32

0.55

80%

(NOC)

Northrop Grumman

7.42

1.37

3.84%

              0.25

0.37

90%

(GD)

General Dynamics

9.02

1.61

3.29%

              0.28

0.28

75%

 

Lockheed Martin is involved in countless homeland security and defense projects. Its aeronautics segment designs and creates military aircraft. Its electronic systems segment takes this theme to sea by providing boat and submarine combat systems. If the enemy wasn’t dead enough already from explosives deployed from aircraft, boats, and submarines, Lockheed will blast him from a space network. Its space systems segment is responsible for satellite linked missile systems. With money to burn, I suppose there is no missile deployment vector too exotic, expensive or redundant.

Lockheed is highly leveraged with a 4.11 debt-to-equity ratio. This is a precarious capital structure and might not withstand budget cuts. Furthermore, Lockheed has a 0.42 payout ratio, which might not withstand budget cuts either. Expect any (much needed) cost cutting to adversely affect stock prices and possibly force a dividend cut.

Raytheon (NYSE: RTN) has a healthier capital structure and more robust dividend policy, though it is like Lockheed in that it depends heavily on military projects.

Raytheon provides the nervous system of military operations: intelligence systems, electronics, and communications. Its systems are used in missile systems, which apparently the US government is addicted to. Raytheon’s clients include foreign militaries, NASA, the FBI, the Department of Defense, and the Department of Homeland Security. If austerity becomes popular, Raytheon will see revenues and earnings decline.

Northrop Grumman has had a higher fraction of revenues from the US government than the other firms on this list, but does not have the leverage of Lockheed Martin or even Raytheon. It’s products are like Raytheon’s in that they provide hi-tech products and services for military operations.

General Dynamics overlaps with Lockheed in that it makes ships, aircraft, and other vehicles for the US military. Fortunately, it is not as leveraged as Lockheed and may be less of a risk in this respect.

Clearly, these four aerospace companies will suffer as more Americans realize that they will have to choose between funding government programs, entitlements, and discretionary military spending. Does this mean that investors weary of military cuts must steer clear of aerospace all-together?

No. Fortunately there are aerospace companies which do not derive the lion’s share of their revenues from military spending. Boeing’s (NYSE: BA) largest segment is Commercial Airplanes rather than its Boeing Military Aircraft segment. Like Lockheed it is highly leveraged with a 2.31 debt-to-equity ratio, though its diversification away from changes in discretionary military spending makes it a safer bet. Better yet, Honeywell (HON) is also less dependent on military spending but is not capitalized as much by debt. Since Honeywell has a lower 0.67 debt-to-equity ratio, it is better able to cope with austerity measures.

Conclusion

The role of the United States in the world is changing and the vestigial military spending of a Cold-War past and escapades as a global policeman is unsustainable. As the United States government reacts to the constraints of promised entitlements and an aging population more funding will be yanked away from military-focused aerospace contractors. 


BobbyFisher has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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