Defense Industrials Are Becoming Only Dividend Plays

Includes: BA, GD, LMT, NOC, RTN
by: Matthew Potter

The five large defense industrial companies are facing a challenging near-term run because of U.S. planned defense cuts. They do have some balance with commercial work versus solely government contracts. This is especially true of Boeing (NYSE:BA) with its commercial aviation business, but most will still rely heavily on U.S. and allied spending for their business. Previous attempts by defense contractors to expand into commercial lines such as Grumman's bus and train business line in the 1980s have failed, usually at great expense.

Even so, it can be expected that revenue and earnings will suffer if the cuts are fully implemented. The U.S. will end up spending billions less on new hardware and advanced systems. This is where these companies make big money. At the same time, they face increasing competition for sales internationally.

There has been some preparation for this new market situation. All of them have concentrated on decreasing their cost models, partly to maintain their profits, but also due to the Pentagon's drive for cheaper prices. This means they have been reducing benefits, eliminating overheads, and cutting their workforce. This has led most of them to report better earnings over the last year, even though revenue has remained flat. The British large defense contractor, BAE Systems, was able to increase income substantially, despite a drop of revenue of almost 20%. This was done primarily by reducing the workforce.

Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), General Dynamics (NYSE:GD), Raytheon (NYSE:RTN) and Boeing all pay decent dividends. The spread ranges from Lockheed's high of $4.00 annually to Raytheon's $1.72. These companies have increased their dividends over the last five years, and there are no signs they will not do so in the future. This makes owning their stock from that consideration alone, attractive.

At the same time, their stock values have trended to be flat. Over the last 52 weeks, only Lockheed and Boeing have seen an increase, and this has been at less than 10%. GD, Northrop, and Raytheon have all seen a decrease, with GD seeing the most at -9.3%. With the budget plans proposed by the Obama Administration, and the need to cut billions from the defense budget over the next 10 years, stock prices should still be soft.

The U.S. proposed cuts will place more pressure on the revenue of these companies. There is the chance of international business, but large, expensive contracts may be hard to win. India, for example, has just chosen France's Dassualt Rafale jet over a variety of offerings from the U.S. and Europe. This, along with Brazil and the United Arab Emirates (NASDAQ:UAE) upcoming fighter contests, was one of the few major acquisitions out there. This limits future opportunities for U.S. defense companies.

What all this means is that as a value investor, your only chance is to use the dividend to generate some rate of return. While Lockheed has one of the best payouts, it also has the highest price at almost $88 a share. Raytheon is the cheapest at under $50, but its dividend is less then half of Lockheed's. This all continues to point to Lockheed as being the best value, but a spread across the different companies might be best.

Boeing certainly has the best chance to increase its revenues and performance in the next few years, as it begins deliveries of the 787 and 737max airliners to the world's airliners. They also benefit from a big push by the U.S. government for export-import support. That means, despite their lesser dividend, there might be more upside in their stock.

This assumes that there will be no major M&A among these five companies leading to disruption in their stock prices and businesses. The next five years, if the budget plans hold, will be flat or down for the defense industry with these five corporations bearing the brunt of that plan, and this should significantly affect their performance.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.