The Good, the Bad, and the Ugly of Defense Stocks

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With sequestration looming on the horizon and Washington’s failure to pass a working budget, it is difficult to anticipate where the axe will fall in March. What we can say with relative certainty is that a reduction in defense spending is imminent.  As an optimist, I see a market decline in defense stocks as an excellent opportunity to add some really great, dividend paying companies to your portfolio at a potentially significant discount. However, some due diligence is in order before you go snatching up every underperforming stock you can find in this arena.

In the spirit of maintaining optimism, let’s get the ugly duckling out of the way first. General Dynamics (NYSE: GD) operates in five business segments consisting of aerospace, combat systems, marine systems, information technology, and commercial sales consisting primarily of private jet aircraft.  Government contracts account for 66% of net revenue with the remaining 24% derived from domestic and international sales to private customers. The company has already experienced a considerable decrease in revenue in its combat systems segment with the conclusion of the wars in Iraq and Afghanistan, and this trend is likely to continue regardless of any change to the defense budget. 

As for the commercial sales segment, with macroeconomic conditions being what they are at home and abroad, it is likely that the jet airline market will remain depressed for the foreseeable future.  Lastly, and probably most concerning, is that the information technology and services segment has suffered a nearly 14% decrease in operating margins in the last year, which does not bode well for a company that will likely rely heavily on revenues generated from this segment going forward.

I have a hard time placing a negative label on Lockheed Martin (NYSE: LMT) given its impressive line of amazing products and recent dominance in the market. Let’s just say they are the good, but not ‘goodest,’ of the actors in this article, and here’s why. Government contracts make up 82% of the company’s net revenue, making Lockheed Martin most susceptible to a negative fall-out from any amount of reduction in defense spending. The company operates in similar business segments as General Dynamics, but most heavily in aerospace and space systems. Some of Lockheed Martins’ most notable projects are the F-22 Raptor, F-35 Joint Strike Fighter, C-130 Hercules, and unmanned aerial vehicles. 

These big ticket items are likely to lose some marketability under new budget constraints and were ultimately designed for full scale combat operations which the U.S. is no longer involved in. The bright spot, however, is that Lockheed Martin has a host of high tech communications systems and is heavily invested in its rather vibrant drone aircraft project; both projects seem to align well with the strategic goals of national defense and should remain insulated from any major cut in government spending, making Lockheed Martin a watch list worthy stock, and a potential picker as the budget debate unfolds.

Now for the actionable intel. Raytheon (NYSE: RTN) is the company best suited to weather a reduction in defense spending, and the stock should be ripe for the picking by March as long as negative sentiment towards defense stocks persists. The company operates in six business segments, all of which are focused on defensive weapons systems, early threat detection, communications, and information technology and services. Raytheon is heavily incorporated in the current national defense structure holding contracts with various government organizations ranging from the Department of Justice, Department of Defense, and Homeland Security.

Raytheon is largely focused on the information technology and services segment of its business model and will likely benefit from this position in the future.  Overall, the company relies on the U.S. Government for 75% of its net revenue. Raytheon currently holds 15,000 active contracts, however none of which account for more than 5% of total net revenue, which should help to insulate the company when the red ink begins to fly in Washington.  

SofJay has no position in any stocks mentioned. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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