Government Belt Tightening is Creating an Opportunity for Defense Stocks

Nihar is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The election is history and now we have a Democratic president amid fiscal cliffs, deficits, national debts, and a weak economy. Cutting defense spending is anathema to the public consciousness, or maybe just the political consciousness. The reasons I do not like that knee-jerk reaction to defense budget cuts actually deals more with military and technological superiority instead of some misplaced desire for everyone to get along. The defense budget is always "frozen" instead of cut. Any cuts or freezes will hurt defense stocks in the short-term, but it might force them to innovate. Innovation benefits everyone, and will eventually benefit the share price.

Weapons Are a Lucrative Trade

If you survey the recent news for Raytheon (NYSE: RTN), the company is winning contracts from international customers and from the U.S. military. It seems that international contracts are bigger than the U.S. ones, but I am sure not all things are made public. The importance of U.S. contracts cannot be understated. It is well known that the U.S. spends more on defense than any other country in the world by a wide margin. If that source is drying up or even remaining stagnant the entire industry could see poor results. We are not going to know everything until the cliff is averted and a budget comes out, and at most I expect the can to be kicked down the road. The U.S. government has limited guidance far into the future. With all that in mind, we should evaluate using a conservative outlook on U.S. spending. However, other countries might continue making upgrades and buying new systems.

The contracts for Raytheon are too many to get into, and I would rather just consider the entire picture. Earnings per share have been growing for the last few quarters, and have been on an overall uptrend for the last five years, with $5.79 as the most recent EPS diluted TTM. Other factors such as cash and debt look good. The profit margin of around 8% is in line with the past. A larger margin would be nice, but it is understandable considering contracts go to the lowest bidder. Companies have an incentive to pass on any savings from cutting expenses down to customers. The profit margin was the only thing that furrowed my brow until I really thought about it.

I like the 3.50% dividend yield, which has been increasing for the last few years. Since the stock is very near its 52-week high I would wait for something to take it further down. The gap between the 52-week high and low is narrow, so you are not looking for a breakdown. I also do not expect a rapid breakout. I would hope that uncertainty over U.S. policy will take its toll on stocks and provide a great entry into an appreciating stock with a solid dividend. The stock is not as high as it was five years ago, but the last three years were good on average. The company is fortifying itself against shrinking U.S. revenues by looking internationally. If the U.S. can sort out its problems, then the company will be poised to gain on both ends, and revenues should appreciate. For now, assume the U.S. will be problematic for some time.

Air Superiority is Important

Much of that analysis applies to Lockheed Martin (NYSE: LMT) as well, and that company yields an even better dividend yield (5%) with a history of growth. The debt-to-equity ratio is scary at 2.672, but it was at 6.454 last year. It is still above its normal ratio, which is around 1.3. It is somewhat understandable considering that Lockheed has more large-scale production like transport planes and fighters. That means a larger, more expensive manufacturing base. Lockheed has been no slouch about getting contracts. Air forces around the world have planes that work and can be kept in the air with proper maintenance. In times of belt-tightening I would turn to the original manufacturer for maintenance.

If you really did want guns and planes, I would take Raytheon and add some Boeing (NYSE: BA). The company's mix of military and civilian aviation makes it a nice complement to Raytheon. I would never want too much exposure to defense, and I feel like Lockheed is almost all defense, while Boeing is more civilian. That might seem arbitrary, but I have never flown in a Lockheed plane. I think the Dreamliner and all the commercial operations will insulate Boeing from government spending headwinds. Obviously any defense related projects are subject to these concerns, but commercial aircraft removes some of that risk. The design has a long life with upgrades, and I am sure the company will hammer out any issues. Commercial aircraft is management's focus, and I think that is right on the mark. Lockheed does have its impressive dividend yield, but I prefer the mix of Raytheon and Boeing.

TheArchivist has no positions in the stocks mentioned above. The Motley Fool owns shares of 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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