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Defense Stocks May Not Be Defensive Stocks

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October 17, 2012 – Comments (0) | RELATED TICKERS: LMT , RTN , GD

When the economy and the market starts heading south, many investors start buying dividend growth stocks. They have long been considered a defensive position in turbulent times. Given many investors recent defensive stance, one might ask how about some real defense stocks, as in the Aerospace and Defense industry.

With a steady flow of government money, defense stocks have long been considered a safe haven when the economy slows down and the market begins to sputter. However, with so many countries around the world, including the U.S., facing huge budget deficits defense spending is where many politicians are looking for significant spending cuts.

As a result of the 2011 Budget Control Act, which will take effect in January 2013, the U.S. Department of Defense must reduce spending by $450 billion over 10 years, and this number could expanded to more than $950 billion. In addition, product demand from defense manufacturers will likely worsen as the U.S. continues to withdraw troops from Afghanistan.

Below are several defense stocks to consider and how thy might be affected in the future:

Lockheed Martin Corp. (LMT)
This company, the world's largest military weapons manufacturer, is also a significant supplier to NASA and other non-defense government agencies. With about about 93% of its revenues from global defense sales, LMT will be hard-pressed to escape unblemished when the budgetary ax falls. Anticipating upcoming cuts, the company has reduced its workforce head count to 123,000 in 2011 from 146,000 in 2008.

The stock boasts a yield in excess of 4.9%. However, its high free cash flow payout and high debt to total capital give me concern as to the long-term sustainability of its dividend. For now, I am not adding to my LMT position and giving serious to reducing it further.

Northrop Grumman Corp. (NOC)
This company is the world's third largest producer of military arms and equipment, with about 90% of its revenue from defense, and also has a large government IT services business. To the company's credit it has streamlined its business to focus on more profitable contracts such as command, control, communications, computers, intelligence, surveillance, and reconnaissance, or C4ISR; cybersecurity; unmanned aerial systems; manned aircraft; and services and logistics.

NOC's lower yield of 3.2% reflects stronger balance sheet, low free cash flow payout (20%) and low debt to capital (27%). NOC should be in a better position than LMT to maintain it dividend, but ultimately its ability to do so will depend on the depth of defense spending cuts.

Raytheon Co. (RTN)
Raytheon, the world's sixth largest military contractor, specializes in making high-tech missiles, advanced radar systems and sensors, defense electronics and missile-defense systems. Increased aggression by certain regimes could provide near double-digit international growth for missile defense and electronics in Asia and the Middle East. However, this growth likely will not offset weakness elsewhere.

Yielding about 3.6%, RTN has a good balance sheet, low free cash flow payout (36%) and good debt to capital (35%). The stock is trading slightly above my calculated fair value of $53.51. RTN is a stock I would be willing to buy in modest amounts as conditions warrant.

General Dynamics Corp (GD)
General Dynamics is the world's fifth largest military contractor and also one of the world's biggest makers of corporate jets. GD may be in a slightly better position to weather future budget cuts due to a diversified line of well-entrenched products and a robust aerospace business. In addition, a strong backlog, particularly for large-cabin aircraft, will will provide good near-term demand.

GD's 3.1% yield (high by historical standards), strong balance sheet, low free cash flow payout (25%) and low debt to capital (22%) make it an appealing stock. In addition, the stock is trading below my calculated fair value of $70.71. I see GD as one of the survivors and thus will continue to moderately add to my position as conditions warrant.

Aerospace and defense companies that do a lot of government work usually enjoy long contracts and are in a good position to weather economic downturns. However, to varying degrees, each of the above companies also is engaged in non-government commercial business that will be more affected by the economic downturn and the budgetary pressure will strain future business. There is certainly a spot for defense stocks in my dividend growth portfolio, but I will patiently wait for the right time and entry price.

Full Disclosure: Long LMT, RTN, GD. See a list of all my dividend growth holdings here.

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