Playing Defense with General, Northrop and Raytheon

The Economist noted yesterday (March 18, 2009) that America accounted for $1.2 trillion in military spending in 2007, or 45% of the entire world’s expenditures in this area. That was more than the next 14 biggest countries spent combined. Russia announced yesterday that they are beginning a comprehensive rearmament as NATO advances into parts of the former Soviet Union. China said it would increase its military spending by 14.9% to about $70 billion this year. War may be hell but it doesn’t come cheap.

President Obama seems determined to prove he is no pushover on national security and wants to present a strong image as Commander in Chief. Our defense budget is not likely to be going down anytime soon.

Despite this robust macro industry view, many of the best quality defense companies have recently hit new multi-year lows. I bought three in the past week that seem like exceptional values right now. All have better than average earnings predictability, A+ or A++ financial strength ratings and top safety ratings (from Value Line). All three have attractive and well covered dividend yields that exceed today’s bank CD rates.

Here are my new purchases and my take on what they might be worth over the next 12 – 18 months:

• General Dynamics (GD) March 18, 2009 close: $39.22
• 52-week range: $35.28 (March 6, 2009) - $95.13 (May 19, 2008)
• Dividend = $0.38 quarterly = 3.88% current yield

Consensus estimates now run $6.08 and $6.37 for 2009 & 2010 making GD’s multiple a stunningly low 6.5x this year’s and 6.1x next year’s expectations. That’s the lowest valuation for these shares in about 20 years.

General Dynamics has a 10-year median P/E of 16 and Value Line looks for a 14 multiple as a ‘normalized’ figure for the long term. Fourteen times the $6.08 estimate would bring these shares back to > $85 /share.

Is that crazy? Nope. GD shares traded as high as $78 in 2006 on EPS of $4.20 and were $94.60 and $95.10 at their peaks in 2007 and 2008. They were $61.50 just this past January.

The 3.88% yield is the best in decades. The previous best yields were set at 2.76% and 2.40% in early 2000 and early 2003. Buyers near 2000’s lows saw their shares go from a [split-adjusted] $18.10 to $55.60 in the next 26 months. Those who got in during March 2003 watched GD surge from $25 to > $61 in under 30 months.

• Northrop Grumman (NOC) March 18, 2009 close: $38.82
• 52-week range: $33.81 (March 6, 2009) - $80.63 (March 19, 2008)
• Dividend = $0.40 quarterly = 4.12% current yield

Consensus estimates now run $4.83 and $5.64 for 2009 & 2010 making NOC’s multiple a historically low 8x this year’s and < 7x next year’s expectations. That’s the lowest valuation for these shares since early 2000.

Northrop Grumman has a 10-year median P/E of 16 and Value Line looks for a 14 multiple as a ‘normalized’ figure for the long term. Fourteen times the $4.83 estimate would bring these shares back to $67.62 /share.

Is that an achievable target price? Sure. NOC shares hit peak prices of $71.40, $85.20 and $83.40 in 2006-2007-2008 and were > $50 since

January 1st this year. Buyers of NOC shares in March 2000 with a similar P/E to today’s, saw their shares skyrocket from a [split-adjusted] $21.30 to $67.50 over the next 26 months.

The current yield of 4.12% in the highest since 1993 and represents just a 34% payout ratio on expected earnings.

• Raytheon (RTN) March 18, 2009 close: $36.33
• 52-week range: $33.20 (March 12, 2009) - $67.37 (April 9, 2008)
• Dividend = $0.28 quarterly = 3.08% current yield

Consensus estimates now run $4.63 and $4.97 for 2009 & 2010 making RTN’s multiple just 7.8x this year’s and < 7.5x next year’s projections. That’s the lowest valuation for these shares that I remember seeing.

Raytheon has a 10-year median P/E of 19 and Value Line looks for a 15 multiple as a ‘normalized’ figure for the long term. Fifteen times the $4.63 estimate would bring these shares back to $69.45 /share.

Is that a stretch? I don’t think so. The 2007 and 2008 highs for RTN were $65.90 and $67.50 when revenues, cash flow, dividend rates and EPS were all well below what they are today.

The current yield of 3.08% in the highest since 2000 and represents just a 26% payout ratio on expected earnings for 2008.

All three companies have great balance sheets. GD has total interest coverage of 25x while NOC comes in at > 10x and RTN has total interest coverage of >20x.

Value Line rates GD, NOC and RTN at 95th, 95th and 100th percentiles for ‘stock price stability’ (with 100th being best). Betas also come in low at 0.9, 0.75 and 0.70 respectively.

In a dangerous world and a volatile stock market environment, it makes me feel secure to own high yielding, good-quality and low risk shares such as these defense industry stalwarts.

Disclosure: Author recently bought shares of GD, NOC and RTN.

Comments

[Larry House:]

I like all of these companies, but the big unknown is how they will fare under this administration. They are at current levels because of that very reason.

Mar 19 04:45 PM

[Graham Jervis:]

Hi Paul,

Just out of curiosity, why didnt you apply the Covered Call Put option play on these 3 companies?

Mar 19 05:09 PM

[anarchist:]

In today's market those dividends don't sound so interesting. If one wanted to play a move up why not buy some Jan 10 call options at or a little lower than the prices projected in this article for a few pennies per share?

Mar 19 07:42 PM

[TaurusTrader:]

I don't buy these stocks for dividends. These are no doubt good companies, but the problem right now is the 'uncertainty' on how the new administration will handle defence budget and contracts.

My 'defensive' dividend paying stocks are like VZ or NLY or VOD or MO .... Not too fancy, but steady at all conditions with above average dividend.

NLY just announced 0.50 cents per share dividend. The stock consistently trades between $14 and 15. You can also write covered calls almost everymonth without being called out and pocket the premium!

TaurusTrader
www.taurustrader.wordp...

PS: I'm long on NLY.

Mar 19 10:26 PM

[Teutonic Kn...:]

Paul,

I'd like your analysis of these 3 companies, but heuristically I think your price projection of their stock is a bit high. My only thesis is that a very high percentage (no exact researched figures here to support, sorry for being tardy) of their revenues are from the U.S. Government, and that single source is either fixed, or on the wane in the next several years.

teutonic

Mar 19 11:03 PM

[The Hammer:]

Yes on the surface the stocks look cheap. The question is what programs are at risk and are up for renegotiation? How much of their profits come from under estimating and over runs?
without a doubt defense contractors have been in a sweet spot for last 8 years. A business so reliant on one customer, the US government has its risks. The US govt is highly indebted and at some point foreigners will force the hand of the US govt to reduce spending or else.
Where is the easiest area to cut? Just look where clinton cut.

Mar 20 08:23 AM

[blonde molly:]

GD has $74b in backlogs.

Mar 20 08:55 AM

[Teutonic Kn...:]

The Hammer:

I concur with you. So refreshing my memory to the beginning of the Clintonian years, would you say big programs such as the missile shield (Poland wise) and possibly the F-22 (procurement numbers) would go first?

Thanks for your insight in advance.

teutonic


On Mar 20 08:23 AM The Hammer wrote:

> Yes on the surface the stocks look cheap. The question is what programs
> are at risk and are up for renegotiation? How much of their profits
> come from under estimating and over runs?
> without a doubt defense contractors have been in a sweet spot for
> last 8 years. A business so reliant on one customer, the US government
> has its risks. The US govt is highly indebted and at some point foreigners
> will force the hand of the US govt to reduce spending or else.<br/>Where
> is the easiest area to cut? Just look where clinton cut.

Mar 20 09:13 AM

[Teutonic Kn...:]

blonde molly:

Not betting against the defense sector, I believe some of the backlog orders are options. If the government chooses not to exercise them for any reasons, the business and ensuing revenue would not be realized.

A notable example is BA, (and Airbus too). On the books they have orders from the airlines, but a lion share of those belong to options. As a matter of fact, some analysts predict that in the worst case scenario, BA and Airbus would only receive half of their optioned orders for 2009-2010.

teutonic

On Mar 20 08:55 AM blonde molly wrote:

> GD has $74b in backlogs.

Mar 20 09:19 AM

[samwise:]

way 'till this administration orders the DOD to start killing "Americans." then their stock price will really go up.

Mar 20 02:19 PM

[jstratt:]

Excellent article! I will only add that in todays environment, earnings in defense stocks are safer than many others.

Also we are in an economic time that can be dangerous. As the author pointed out defense budgets around the world are rising. I could be mistaken but Ukraine is beginning to look more like a future Russian province.

Finally it is Congress that appropriates and Congress rarely disappoints its constituents.

Mar 20 08:14 PM

[Paul Price:]

Raytheon board hikes dividend 11%

RTN 37.23, +1.20, +3.3%) said late Wednesday its board raised the dividend 11%, resulting in a quarterly dividend of 31 cents and an annual dividend of $1.24. The quarterly dividend is payable May 1 to shareholders of record as of April 7.

Mar 25 05:38 PM

[Paul Price:]

Raytheon Co. (RTN) - A ZACKS BUY
By Alex Kolb
May 11, 2009

Raytheon Co. (RTN) has seen a swift rebound off recent multi-year lows and compares favorably to the market over the past year. Analysts are bullish on RTN’s earnings for both 2009 and 2010, calling for annual growth of 16% and 6%, respectively.

Bullish Forecasts

Current full-year earnings estimates of $4.71 per share were boosted by 16 out of 20 covering analysts from last month’s projections of $4.63 per share. For the following year, 9 out of 19 covering analysts hiked earnings forecasts by a penny from last month’s $5.00 per share.

The company boasts an outstanding track record of topping analysts’ estimates since July 2004. During the past 4 consecutive quarters, earnings were, on average, 7% above forecasts.

A Recent Contract

The company most recent contract announcement was a $7.3 million deal for the continued production of ALR-69A(V) radar warning receiver systems for the Warner Robins Air Logistics Center in Robins Air Force Base, Georgia.

Solid Earnings

In late April, Raytheon posted first-quarter earnings of $1.11 per share, beating the previous year’s 93 cents and exceeding the consensus estimate by 11%. Net sales of $5.9 billion increased 10% on a year-over-year basis.

Shares of RTN are on a rebound after falling with the market. Shares received an extra boost on strong first-quarter results and have traded ahead of the broader market over the past year.

May 11 12:31 PM

[Paul Price:]

Defense Scores - Barrons

MONDAY, MAY 25, 2009
SPEAKING OF DIVIDENDS - Barrons

By SHIRLEY A. LAZO

Military contractor Northrop Grumman is in fighting trim.

DEFENSE STOCKS TOOK FLIGHT IN MID-MARCH after the Pentagon's proposed 2010 budget didn't turn out to be as stingy as feared. Take Northrop Grumman , the subject of an upbeat piece by Barron's senior editor Jay Palmer on March 9. Jay thought Wall Street had overreacted to the possibility of defense cutbacks and that Northrop was ripe for a rebound. Indeed, the shares are ahead 40%.

Wednesday, Northrop (ticker: NOC), which has a roster of promising products and robust cash flow, lifted its quarterly common dividend 7.5%, to 43 cents a share from 40 cents, marking the sixth consecutive year of higher distributions. Dividends have more than doubled in that stretch, and have been paid without interruption since 1951. In March, defense-industry brethren General Dynamics (GD) and Raytheon (RTN) raised their quarterlies, too.

Northrop's new dividend is payable June 13 to holders of record June 1, and the stock goes ex-dividend May 28.

Los Angeles-based Northrop is the world's No. 2 military contractor (behind Lockheed Martin [LMT], with Boeing [BA] a close third) and the No. 1 builder of conventional warships and nuclear-powered aircraft carriers. Traded on the Big Board, the shares change hands just under 50 and, with the new payout, yield 3.57%. Their 52-week range is 76.32 to 33.81. The company bought back $1.6 billion of stock in 2008.

Northrop estimates full-year 2009 earnings from continuing operations of $4.65 to $4.90 a share on sales of $34.5 billion. That compares with $5.21 on $33.9 billion in revenue last year. Free cash flow was a record $2.4 billion in 2008, and the company began this year with a record order backlog of $78 billion. This month, Northrop said it sees opportunities to grow in cybersecurity, unmanned vehicles and other areas, as the Defense Department focuses more attention on unconventional warfare.

Wachovia Capital Markets and Morgan Keegan rate the stock Market Perform. Jefferies & Co., which rates it Hold, notes Northrop's senior leadership "has a balance and breadth of experience it has not always enjoyed."

May 23 07:37 AM

[Paul Price:]

Northrop hands Boeing stunning defeat.

Northrop Grumman (NOC) beat out Boeing (BA) for a $3.8B contract to maintain and service the U.S. Air Force's fleet of KC-10 refueling tankers. Analysts said the win was a "stunning upset" for Northrop, given that Boeing has been servicing the KC-10 since its introduction. Boeing said it will review the decision before deciding whether to appeal to the GAO. NOC +5.4% after hours.

Oct 02 08:40 AM

[Paul Price:]

THURSDAY, NOVEMBER 5, 2009
HOT RESEARCH AM - Barrons.com

Upgrading General Dynamics Credit Suisse expects shares to climb 18% from current levels.

General Dynamics (GD: NYSE)
By Credit Suisse ($62.55, Nov. 4, 2009)

WE HAVE DONE A DETAILED HISTORICAL ANALYSIS of General Dynamics' (ticker: GD) trading patterns, business jet operating data and company program outlooks. We find General Dynamics defense programs on balance to have a fairly positive outlook, pointing to a stable forecast for General Dynamics' defense segments through 2012.

Meanwhile, in our recent business jet report (dated Oct. 21), we concluded that General Dynamics' higher-end product line should fare better than peers' in the evolving biz jet market. Based on third-quarter earnings per share (reported Oct. 28), we think Aerospace troughed in sales and margins in the third quarter, and we see sequential improvement in earnings and orders going forward, with first signs likely from the newly expanded (via the Jet Aviation acquisition) aftermarket business in 2010.


We are raising our rating to Outperform; price target rises to $74. While General Dynamics has moved strongly off its March low, we think the market has yet to factor stability in its defense programs in 2011-2012 coupled with potential strong recovery growth in Aerospace in that time frame.

We think General Dynamics' modest 4% war exposure can keep defense earnings intact and historical analysis shows a 10 times multiple (same as peers') is warranted for this segment. The projected Aerospace growth warrants a price/earnings multiple in line with commercial names -- we apply a 15 times multiple on our expectations of trough 2009 EPS. The consolidated multiple of 11 times, applied against our calendar 2010 EPS forecast of $6.72 yields a price target of $74 (18% upside), up from $70, when we used 12.5 times for Aero.

Catalysts include positive economic data. And sequential improvement in Aerospace earnings/orders are future share catalysts. Defense contract announcements, along with the February fiscal 2011 budget release should bring greater comfort for the defense outlook. Risks include a deferred economic recovery and greater-than-expected impact from war withdrawal on Combat Systems, or other unanticipated program cuts.

-- Robert Spingarn

Nov 05 07:12 PM