The early 2000s were a great time for defense contractors. Government spending was at all-time highs, and most of the money was flowing through the Department of Defense. Companies like Lockheed Martin (LMT), Northrop Grumman (NOC), and Raytheon (RTN) raked in the profits. Price was of much less concern to the Department than was the quality of the missile system, the fighter jet, or the IT service they were getting, and in these times immense profits were made by the companies and their shareholders.
We are now in a new era of federal spending. The deficit and high cost of weapons systems deters the Department of Defense from shelling out top dollar to defense contractors the way they once did. More and more often defense contracts are being awarded on the basis of lowest price technically acceptable, and that would seem to spell trouble for some of the big players in the world of defense contracts. I however, look at this as an opportunity.
Congress set a deadline for itself to reach a budget deal by March 1 or $85 billion of automatic spending cuts, "Sequestration" rolls into effect. With each day that passes, it seems more and more likely that Congress is inclined to go into Sequestration, and eventually come to a deal to reduce the pain of the spending cuts. In total, half of the spending cuts resulting from the U.S. entering the sequester directly hit the Department of Defense.
While the impacts of the sequester would undoubtedly have a negative impact on the Department of Defense, defense contractors would likely be hit the hardest. In light of that, it might be a surprise that I would consider purchasing shares of defense contractors, but I look at this as a potential buying opportunity. With the threat of sequestration many defense contractor stocks are trading at low valuations, and in the event that Congress allows the U.S. to hit the sequester these stocks could become a better bargain.
Lockheed currently trades at $87.53, just 10x TTM earnings, and despite the challenging environment anticipates earnings growth of near 5% over the next five years. With LMT, the real attraction is the dividend. Paying a $4.60 annual dividend LMT currently yields 5.26% and any decline in price would increase the effective yield. At the current rate, LMT is paying out approximately 49% of earnings as dividends, and has grown the dividend by 22.3% annually over the last five years. Lockheed Martin is a great income stock, and if LMT were to decline below $85 I would look to initiate a position, hold long term, and collect my substantial dividends.
Northrop Grumman currently trades at $66.12, representing a price of just 8.5x TTM earnings. NOC anticipates earnings growth of 3.8% over the next five years, and the company has relatively low debt. NOC is another great dividend stock, paying out just 27% of earnings as dividends. With a $2.20 annual dividend, NOC currently yields 3.33%, and the company has averaged dividend growth of 8.25% over the past five years. With the low payout ratio and slow growing earnings, NOC should continue to grow the dividend despite the challenging fiscal environment. I would look to purchase shares of NOC if they trade at or below $63.
Raytheon currently trades at $54.55, which represents a price of just 9.6x TTM earnings, below the five-year average of 11. Raytheon anticipates EPS growth of 5.7% over the next five years, and the company sports an average debt load for the defense industry. Paying out 35% of earnings as dividends, RTN appears to have a safe dividend with significant room to continue growing. With a $2.00 annual dividend RTN sports a current 3.67% yield, and over the past five years has managed 14.4% CAGR. I believe RTN represents the best long-term buy of the bunch, and I would look to purchase shares at $52.00.
The Department of Defense faces a significant challenge, and that challenge will directly impact the bottom line for the country's top defense contractors. In order to remain competitive these large defense contracting firms must adjust and evolve. The large defense contractors must become more agile, streamline operations, and reduce overhead to bid more competitively. While the companies listed above may represent sound investments there are many other defense contractors to consider, and significant risks associated with these investments given the current fiscal climate. Stocks like General Dynamics (GD) and Boeing (BA) are certainly worth consideration, as are some of the more IT centric contractors such as IBM (IBM) and L-3 communications (LLL).