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Why I'm Holding Lockheed Martin in Spite of Possible Defense Cuts

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The defense industry is in the middle of a swirl of headlines regarding impending budget cuts in the United States.  This threat is an overhanging risk for any of the major U.S. defense firms that rely on government contracts, primarily Lockheed Martin (NYSE: LMT), Raytheon (NYSE: RTN), and Northrop Grumman (NYSE: NOC).  The question to investors now is, should shares in these firms be dumped?

Sequestration, the $1.2 trillion in defense and non-defense discretionary budget cuts scheduled to go into effect this year, has many investors worried.  Indeed, Lockheed Martin derived 82% of its revenues from U.S. government contracts in 2011, including 61% directly from the Department of Defense budget.  The full impact of sequestration is unknown.  Lockheed acknowledged in its 2011 annual report that further significant cuts to military spending could cause material harm to its business.  In particular, investors in Lockheed Martin should pay close attention to the status of the company’s F-35 program.  The F-35 is Lockheed’s largest program, as it accounts for 13% of its sales.  Furthermore, the F-35 program is expected to represent an even higher percentage of the company’s sales in the future.

It appears that at least some of the expected cuts are priced into the shares of these defense companies.  Lockheed, Raytheon, and Northrop Grumman trade at trailing price-to-earnings ratios of 10.7, 10.1, and 8.7, respectively.  Furthermore, the dividend yields on these companies beat the yield on the broader market.  In an environment of historically low interest rates, the dividend yield on these three firms is attractive to many income-seeking investors.  Raytheon and Northrop Grumman both yield in excess of 3.3%, while Lockheed Martin has an even higher yield of almost 5%.

A positive note for Lockheed Martin is that it will not suffer from the drawdown of operations in Iraq and Afghanistan.  Funding of the two wars was confined under the Overseas Contingency Operations budget, which is separate from the Department of Defense budget.  The Department of Defense budget is where Lockheed Martin derives 61% of its U.S. government contracts, and that budget is only going to contract by about 1% in fiscal 2013 versus the prior year.  The Overseas Contingency Operations budget is where harsher cuts will be enacted.  Because of the gradual end to the wars in Iraq and Afghanistan, that budget will see cuts of almost 24% in fiscal 2013.

In spite of the threat of defense spending cuts, Lockheed expected only a slight decrease in 2012 net sales and operating profit in its 2011 annual report.  In fact, Lockheed’s net sales have actually grown by more than 2% during the first nine months of 2012.  Diluted earnings per share increased by more than 15% during the first three quarters as the company aggressively repurchases shares.  Lockheed has made it a priority to get in front of the threat of sequestration, noting in its 2011 annual report that the investments and acquisitions Lockheed made have been focused on what Lockheed believes are the most critical national priorities and mission areas.

A reality of the world we live in is that governments are constantly encountered with new security challenges, and Lockheed Martin should continue to perform well.  Lockheed Martin expects its operating margin to remain stable going forward, and it continues to be committed to returning at least 50% of free cash flows to investors through dividends and share repurchases.  Lockheed has increased its dividend by more than 22% annually over the last five years.  Until the headline risk is reflected in Lockheed’s free cash flow and dividend growth, I will continue to hold my shares.

Robert Ciura owns shares of Lockheed Martin. 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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