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The defense industry is home to a number of large defense contractors - General Dynamics (NYSE:GD), Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC) and Raytheon (NYSE:RTN) - that have significant project/intellectual know-how, long-term customer/government ties, and widespread integration expertise that cannot be easily replicated by many smaller contractors. This gives established, large defense contractors a leg up on bidding for new government contracts and optimizing the margin profile for many through cost cutting and productivity enhancements. Still, competing budget priorities within the overall US budget and within the US defense budget itself will pose both challenges and opportunities for much of the group.

However, long-term cybersecurity and national security risks aren't going away, and this will ensure that the group has a steady share of funding in the US and opportunities on the international market for many years to come (and arguably into perpetuity). Though we very much prefer commercial aerospace exposure at this juncture-meaning, on a fundamental basis, we like Boeing (NYSE:BA) the most out of the large defense contractors-we do applaud the healthy balance sheets and free cash flow characteristics of the large defense contractor constituents. This bodes particularly well for future dividend increases across the industry, even if overall defense spending may be pressured in coming years.

Let's dig into the outlooks from the largest defense contractors.

General Dynamics' Earnings Outlook Disappoints, Backlog Continues to Shrink

On January 22, General Dynamics issued full-year 2013 revenue that was marginally lower. The company's 'Aerospace' revenue advanced nicely, but its 'Combat Systems' revenue dropped more than 20% during the year. With a focus in Washington on reducing combat activity and America's involvement in wars, we're not expecting a return to growth in the firm's 'Combat Systems' division anytime soon. General Dynamics also expects continued declines in the segment, as outlined on its conference call:

"In 'Combat Systems,' we expect a more modest revenue decline of about 4% to 4.5%. Embedded in this plan is about $1.2 billion of revenue for the same international program that slipped to the right last year. We anticipate a first quarter order. If not received on that schedule, we will have further erosion of revenue from this guidance and we will address its impact directly with you in the second quarter."

The defense contractor issued earnings per share guidance of $6.80-$6.85 which was below the $7.03 mark it registered in 2013. With its backlog dwindling (now $46 billion, was $47.9 billion in the third quarter of 2013 and $51.3 billion in the fourth quarter of 2012), most of the potential earnings upside this year will come from opportunistic share buyback purchases and efficiency and/or cost-cutting initiatives. Though we think General Dynamics' valuation indicates that a better entry point can be had, its dividend growth potential is quite robust, especially given the size of its yield. We're watching shares closely.

Lockheed Martin Expects Further Sales Pressure But Earnings Expansion

Lockheed Martin issued full-year 2013 results January 23 that showed top-line pressure almost across the board (its 'Missiles and Fire Control' was the only segment showing an increase for the year). However, earnings and cash-flow performance did improve from the prior year.

"Net sales for 2013 were $45.4 billion compared to $47.2 billion in 2012. Net earnings from continuing operations in 2013 were $3.0 billion, or $9.04 per diluted share, compared to $2.7 billion, or $8.36 per diluted share, during 2012. Cash from operations for 2013 was $4.5 billion after pension contributions of $2.25 billion compared to cash from operations for 2012 of $1.6 billion after pension contributions of $3.6 billion."

For 2014, the defense contractor expects more of the same and issued a net sales revenue outlook of $44-$45.5 billion, the midpoint lower than that achieved in 2013. Diluted earnings-per-share, however, is expected to expand to the range of $10.25-$10.55, materially higher than the $9.04 mark last year. Lockheed Martin's backlog expanded $300 million at the end of 2013 from last year's level, and the company is expecting a strong pace of orders during 2014 to the tune of $41.5-$43 billion. However, those order levels imply a book-to-bill less than 1, and by extension, potential future revenue declines into 2015. Any earnings upside above the target range for 2014 will be driven by efficiency and productivity maneuvers, not by better-than-expected revenue performance, in our view. Lockheed Martin's share price is ahead of its fundamentals (at the time of this writing), so we're not rushing to enter shares with new money. However, the company's dividend is very solid, particularly in light of its strong cash flow expansion (cash flow from operations is expected to be greater than $4.6 billion during 2014).

Northrop Grumman's Revenue Outlook In-line With Industry

On January 30, Northrop Grumman issued full-year 2013 results. For 2013, sales dropped modestly ($24.7 billion versus $25.2 billion), which led to a slight decline in operating income versus last year. Net earnings also declined, but diluted earnings per share of $8.35 leapt thanks to share buybacks. Cash flow and free cash flow performance was also worse than last year. The company's order and backlog trends weren't great, but fit the profile of the industry:

Total backlog as of Dec. 31, 2013, was $37.0 billion compared with $40.8 billion as of Dec. 31, 2012. The decline in backlog was primarily due to reductions and delays in customer awards resulting from the current U.S. government budget environment as well as Information Systems backlog adjustments of $1.0 billion in the first half of the year, primarily to reduce unfunded backlog for expired periods of performance on active contracts. Fourth quarter 2013 new awards totaled $5.7 billion, and book-to-bill was 92 percent. For 2013, new awards totaled $21.9 billion, and book-to-bill was 89 percent.

Looking to 2014, Northrop Grumman expects sales in the range of $23.5-$23.8 billion and diluted earnings per share in the range of $8.70-$9.00 for the year. The midpoint of the revenue target is below last year's mark, but earnings are anticipated to show solid expansion. As with its peers, we think there may be a better time to enter Northrop Grumman's shares, but its dividend remains solid.

Raytheon Suggests Low Point in Military Spending Will Pass By Mid-2014

Raytheon issued full-year 2013 results January 30. Net sales dropped nearly 3% ($23.7 billion), while adjusted income fell 1.4% ($2.07 billion). However, adjusted earnings per share nudged higher (1.6%), and so did operating cash flow for the year. Both bookings ($22.1 billion versus $26.5 billion) and backlog ($33.7 billion versus $36.2 billion) fell from last year's measures, performance that was in-line with industry trends. For 2014, net sales are expected to decline to the range of $22.5-$23 billion, and adjusted earnings per share are expected to fall to the range of $5.76-$5.91 (versus $6.38 per share in the year-ago period). Though Raytheon's results weren't unlike those of its large defense contractor peers, we were slightly encouraged by management's comments that the low point in military spending will pass by mid-2014. Raytheon's valuation and dividend profile also fit that of the rest of the industry: there's a better entry point, but dividend growth should be expected.

Valuentum's Take

Competing government budget priorities will continue to make top-line expansion difficult for the largest defense contractors, but cost controls, efficiency initiatives and buyback programs will make earnings-per-share expansion possible. In any case, we expect the group to continue raising dividends through 2014 and beyond on the basis of constituents' strong cash flow trends and healthy balance sheets. Still, we prefer a more diversified defense contractor such as Boeing, which continues to benefit from strong commercial aerospace exposure. We have limited defense exposure in the actively-managed portfolios, but the group is one that dividend-growth investors should pay close attention to.

Source: Dividend Investors: Defense May Be The Place To Be Despite Revenue Headwinds