Nearing Defense Cuts: A Look at 5 Defense Companies

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The automatic across the board cuts (i.e. sequestration), set to occur on January 2, 2013 will cut, over the next 10 years, about $500 billion out of the Department of Defense (DOD) budget. This is on top of the $487 billion in reductions, over 10 years, in budget growth already required. If sequestration occurs, the defense budget will be cut across the board by around 10% in 2013. Military personnel and veteran’s affairs are exempted from the cuts (CNN). While sequestration can be avoided by congress, investors in defense stocks should assess the risk by determining which companies in the Aerospace & Defense Industry have high and low exposures. The following list looks at five of the biggest companies in the industry.

High Exposure

1. Lockheed Martin (NYSE: LMT), Market Capitalization: 30.0 Billion

Lockheed Martin, the maker of the F-35 Fighter Jet, is highly dependent on the US government. Lockheed operates in four business segments: Aeronautics, Electronic Systems, Information Systems & Global Solutions, and Space Systems. In year 2011, the U.S. government accounted for 75%, 73%, 93%, and 96% of net sales in Aeronautics, Electronic Systems, Information Systems & Global Solutions, and Space Systems, respectively. Total sales to the US Government accounted for 82% of the company’s net sales, which includes 61% from the Department of Defense. In its 10-Q report the company states, “Current estimates suggest that sequestration would result in an amount in excess of $50 billion, or approximately a 9% or more reduction in the GFY 2013 base defense budget, to approximately $475 billion. At this point, we understand that cuts are likely to be applied across-the-board...Consequently, we expect that sequestration will have a material effect on our results of operations, earnings, and cash flows ...” Lockheed has a trailing PE ratio of 10.6 and a dividend yield of 4.95%.

2. Raytheon (NYSE: RTN), Market Capitalization: 18.4 Billion

Raytheon operates in six business segments: Integrated Defense Systems, Intelligence and Information Systems, Missile Systems, Network Centric Systems, Space and Airborne Systems, and Technical Services. In year 2011, the US Government excluding foreign military sales accounted for 74% of its total net sales. Foreign military sales through the US Government were 12% of its total net sales. In its 10-Q Report, Raytheon states, “ the event funding reductions are made at the levels provided for in the BCA sequestration, such reductions and related cancellations or delays affecting our existing contracts or programs could have a significant impact on the operating results of our business.” Raytheon has a trailing PE ratio of 9.6 and a dividend yield of 3.59%.

3. General Dynamics (NYSE: GD), Market Capitalization: 23.8 Billion

General Dynamics operates in four business segments: Aerospace, Combat Systems, Marine Systems, and Information Systems and Technology. Aerospace designs Gulfstream business jets, Combat Systems builds military vehicles and weapons, Marine Systems builds ships and submarines for the US Navy, and Information Systems and Technology provides critical technology and services. In 2011, the US Government accounted for 69%, US commercial customers accounted for 12%, international defense customers accounted for 9%, and international commercial customers accounted for 10% of the company’s revenue. In its 2011 letter to shareholders, Jay Johnson, CEO, stated, “If enacted, sequestration would place extreme fiscal pressures on our customers, with wide-ranging effects on our industry and the security of our nation.” General Dynamics has a trailing PE ratio of 10 and a dividend yield of 3.03%.

Less Exposure

4. Boeing (NYSE: BA), Market Capitalization: 53.6 Billion

Boeing operates in five business segments: Commercial Airplanes, Boeing Military Aircraft, Network & Space Systems, Global Services & Support, and Boeing Capital Corporation. In 2011, US Government contracts accounted for 38% of Boeing’s revenue. However, 53% of the company’s total revenue is from commercial airplanes. Also in the company’s 2011 annual report, commercial airplanes accounted for 86% of the company’s total contractual backlog of $339.657 billion. The company has a duopoly with Airbus in the commercial airplanes industry. As a result, the commercial airplane industry should be the main driver of Boeing’s business future. Due to the state of its backlog, Boeing faces relatively lower risk to sequestration. Boeing has a trailing PE ratio of 12.5 and a dividend yield of 2.48%.

5. United Technologies (NYSE: UTX), Market Capitalization: 71.3 Billion

United Technologies Corp is a diversified company. It has five business segments: Otis, UTC Climate Controls & Security, Pratt & Whitney, Hamilton Sundstrand, and Sikorsky. The company’s total sales to the US Government accounted for 18% and 17% of totals sales in Q2 2012 and year 2011, respectively. As was previously stated, the company is well diversified. Otis produces elevators and escalators (the world’s largest producer); UTC Climate Controls & Security provides HVAC, fire safety, and security products; Pratt & Whitney supplies aircraft engines; Hamilton Sundstrand provides aerospace products; and Sikorsky builds helicopters. Pratt & Whitney accounted for the majority of its 2011 revenue at 23%. Overall, United Technologies faces relatively low risk from DOD defense cuts. United Technologies has a trailing PE ratio of 13.5 and a dividend yield of 2.74%.

In summary, if Congress does not figure out how to cut $1.2 trillion from the Federal budget, sequestration will kick in on January 2, 2013 and automatically slash the budget by $1.2 trillion. This will result in a cut of about $500 billion to the U.S. DOD over the next decade with an estimated cut of about 10% projected to occur in 2013. While the big companies can definitely handle a 10% decrease in DOD annual spending, the cuts are across the board so it will affect every project (e.g. the companies’ lucrative projects). Also, military personnel are exempted from cuts so the cuts will be felt even more by the rest, which includes defense contractors. For investors who want to minimize risks, Boeing and United Technologies are relatively lower risk ways to stay invested in the defense industry.

Alvin has no positions in the stocks mentioned above. The Motley Fool owns shares of General Dynamics, Lockheed Martin, and Raytheon Company. 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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