The Surprisingly High Yields of Defense Contractors

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The defense sector has been under attack for the last few years as federal government budget cuts pressure the major companies in the sector. The surprising part is that the associated stocks continue to support very strong dividend yields combined with major stock buyback programs.

Lockheed Martin (NYSE: LMT), Northrop Grumman (NYSE: NOC), and Raytheon Company (NYSE: RTN) have not only survived the cuts, but in most cases the companies were able to reduce costs in order to maintain strong profits. Recent analyst estimates suggest that 2013 and 2014 will be better than expected providing support that the dividend yields averaging around 4% will at the least remain intact.

Even better, the stocks have recently been under pressure offering an entry point below recent highs while the market has soared. Another important fact missed by the general thought process of investors is that these companies generally benefit from the expected expansion in the aerospace sector.

Company details

Lockheed Martin had sales of $47.2B in 2012 with a market cap of $28B and a surprisingly record backlog of $82B. The company repurchased 11.3M shares during the year for $1B and has a dividend yield of 5.2%. It expects earnings of nearly $9 for 2013 after reporting $8.36 in 2012.

Northrop Grumman had sales of $25B in 2012 with a market cap of only $15.5B. The company repurchased 20.9M shares during the year for $1.3B and has a dividend yield of 3.4%. It guided towards $7 in earnings for 2013.

Raytheon had sales of $24B in 2012 with a market cap of $17.6B. The company repurchased 15.9M shares during the year for $825M and has a dividend yield of 3.7%. It expects earnings of around $5.70 in 2013 though analysts only expect $5.34.

Earnings Estimates Moving Up

One big way to determine whether a company or sector has reached bottom is to track the path of the analyst earnings estimates. Estimates that suddenly switch from declines to revisions upwards suggest that analysts had become too negative.

The below table highlights the estimate changes over the last 90 days:

 

<img src="/media/images/user_15227/screen-shot-2013-02-14-at-103517-am_1_large.png" />

3-Month Price Change

The most surprising part about the recent earnings revisions is that the market has completely ignored them. As the chart below shows, all of the stocks have drastically underperformed the S&P 500 during that time period:

<img src="http://media.ycharts.com/charts/a6b1492f5ade749ae03ebd0eccf5d380.png" />

LMT Total Return Price data by YCharts

 

Conclusion

Investors looking for high yields should consider these defense stocks. The 5.2% dividend yield of Lockheed Martin is difficult to ignore while the other two stocks offer fantastic yields above 3%. In fact, Northrop Grumman has a net buyback yield of nearly 9% in addition to the solid dividend. The other two stocks routinely buyback stock as well providing substantial returns of capital to investors.

The recent stock declines provide an opportune time to enter the stocks. With the earnings estimates increasing, it suggests the market is very disconnected from the facts. Revenues might be declining, but the companies have been able to reduce costs at a faster pace again highlighting how the general market mistakenly focuses on the top line instead of the more important bottom line.

The sequester remains a risk that is clearly built into these stocks already. The next few weeks will no doubt be turbulent for defense stocks. In the end, politicians will likely find a solution that doesn't involve dramatic cuts to defense spending thereby rewarding patient investors. 


Mark Holder and Stone Fox Capital Advisors, LLC have positions Lockheed Martin, Northrup Grumman, and Raytheon Company. The Motley Fool owns shares of Lockheed Martin, Northrop Grumman, 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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