Many defense industry stocks are out of favor, as investors worry that the winding down of operations in Afghanistan and Iraq, combined with nearly $500 billion in U.S. military spending cuts over the next decade, will drastically curtail defense companies' earnings.
These fears are overwrought. Despite political rhetoric about the need for fiscal austerity, the US Dept of Defense has a history of dodging the budget knife, especially when it comes to weapons systems specifically geared to fight terrorism.
One class of anti-terrorist weapon that will prevail over the long term, regardless of budget deficit concerns: unmanned aerial vehicles (UAV). For defense strategists, pilot-less aircraft outfitted with ultra-sophisticated sensors are a vital tactic in fighting the asymmetrical guerilla wars of the 21st century.
These UAVs are the darlings of reformers in the Pentagon, and Raytheon (NYSE:RTN) is the leader in the field by virtue of its unparalleled expertise in sensor technology.
UAVs are aircraft that fly without a human crew on board, making them completely reliant on sensors. Many are armed with missiles and see action in Iraq, Afghanistan and Pakistan.
Sometimes called pilot-less drones, UAVs are undertaking increasingly sophisticated missions that range from high-altitude surveillance to taking a hunter-killer role on the battlefield.
Raytheon, based in Waltham, Mass., develops products for defense, homeland security and other government markets. Raytheon doesn't build the actual UAV airframes, an intensely competitive line of business. Instead, the company provides the sophisticated sensors that make a UAV work. Raytheon's growth is driven by this specialty.
Dynamic Growth Segment
A potential downside to this investment would be significant cuts in UAV spending, but that's unlikely to occur, even with lawmakers' current passion for deficit reduction. Many places on the planet remain wracked by strife and are well-suited theaters for UAV operations.
The Teal Group, an aerospace consultancy, reports that UAVs are the most dynamic growth segment of the world aerospace industry this decade. Teal's 2012 market study estimates that annual spending on UAVs will almost double over the next decade, to $11.4 billion over the next decade. That amounts to more than $89 billion in expenditures. Sensors account for about 50 percent of these figures.
This spring, the Pentagon proposed a 2013 fiscal year budget of $523 billion that begins to implement $487 billion in spending cuts over the next decade by reducing the size of the military and canceling or scaling back many weapons programs. The proposal would cut $260 billion in spending through 2017, taking the Pentagon roughly halfway to its budget-cutting target for the decade.
The 2013 Pentagon budget slashes big-ticket items such as the F-35 Joint Strike Fighter, but it also implements a plan to increase the fleet of drones by at least 45 percent over the next 10 years. The US military's inventory of unmanned aerial vehicles is slated to grow from about 445 in fiscal 2013 to 645 aircraft in fiscal 2022.
A Missile Heritage
Combine new military and homeland security priorities with contemporary society's squeamishness about human troop casualties, and UAVs are the perfect solution for launching as well as pre-empting attacks. The fast growth of the UAV market has translated into soaring demand for UAV sensor technologies.
Raytheon currently supplies the sensors onboard many UAVs, including the high-altitude RQ-4 Global Hawk.The US Air Force is seeking $1.6 billion in 2013 to buy Global Hawks, making these sensor-intensive machines a big winner in the latest military budget.
Sensors account for 50 percent of a UAV's cost. Raytheon's sensors also are prized by the military for their unique ability to penetrate cloud cover. Raytheon continually develops lighter, high-reliability sensors - exactly what the military covets most.
The company got a head start in the UAV sensor business because of its long heritage in the missile business. As the world's largest missile maker, Raytheon possesses proprietary legacy technology that enables it to create innovative, versatile sensors and guidance systems.
Raytheon's unmanned system sensors account for 17 percent of its revenue mix and 20 percent of its operating mix. The company also contributes content to a wide range of other weaponry popular with Pentagon planners, notably the Tomahawk cruise and Patriot missiles.
Raytheon's leadership in these futuristic technologies has enabled the company to rack up a dramatic return on equity in fiscal 2011 of 19 percent, compared to an aerospace and defense industry average of 17.1 percent.
Despite the impressive long-term trends in its favor, the stock still appears undervalued and currently offers a dividend yield of 3.8 percent. With comparatively little debt and a strong earnings outlook for the next two years, Raytheon's healthy dividend should be sustainable.
Raytheon's price-to-earnings ratio of 10.1 is well below the average of 17.2 for the aerospace and defense industry as a whole and pales in comparison to the S&P 500's price-to-earnings ratio of 15.8. Also, Raytheon has surpassed earnings estimates by at least 6 percent in each of the past three quarters.
For fiscal year 2011, Raytheon reported earnings per share (EPS) of $5.90, compared to $5.51 in 2010, an increase of 7 percent. Raytheon pleasantly surprised investors yet again on April 26, 2012, when it reported a 16 percent rise in first-quarter profit and boosted its full-year guidance.
Earnings rose to $448 million in the three months ended March 31, from $384 million a year earlier. EPS increased to $1.33 from $1.07. Full-year revenue is expected to reach between $24.5 and $25 billion, but the company raised its EPS guidance by 10 cents, lifting the range between $5.00 and $5.15.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.