Should Dividend Investors be Defensive about these stocks?

Everyone knows that the US is running huge budget deficits. As a result, the US has a multi-trillion dollar debt load. Early on in 2013, we witnessed some automatic spending cuts by the Federal government, which affected government spending on defense. We are currently all witnessing the Debt Ceiling theater, which is the ultimate stupidity in the making. In addition, with the wars in Iraq and Afghanistan being close to complete, it looks like companies in the defense sector might have a tough time generating much in terms of earnings and dividend growth over the next decade.

Defense companies earn money from providing products and services for US government. If government pays them for research, and companies can use this knowledge, then this know-how could bolster prospects of earnings significantly over time. The relationship between inventions and profitability is not linear, as it takes time for an idea to come to market and reach a certain level of following, before generating profits. From a long-term perspective however, it could pay dividends for years to come.

The past decade had been tremendously profitable for defense companies such as Lockheed Martin (LMT), Raytheon (RTN), General Dynamics (GD) and Northrop Grumman (NOC). These companies enjoyed rising earnings that allowed them to bump up distributions to shareholders every year. Share prices increased as a result of the improved profitability at these corporations as well. Currently, a lot of these companies are looking attractively valued, and also have above average market yields. The question in the minds of many dividend investors is whether these companies are worth purchasing right now.

Lockheed Martin Corporation (LMT), a security and aerospace company, engages in the research, design, development, manufacture, integration, and sustainment of advanced technology systems and products for defense, civil, and commercial applications in the United States and internationally. The company derives over 80% of revenues from US government and US agencies. Approximately 18% is derived from sales to foreign governments. Lockheed Martin has raised dividends for 11 years in a row. Over the past decade, it has managed to boost distributions by 24.70%/year. The outstanding shares from decreased from 450 million in 2003 to 326 million in 2013. Analysts expect that this dividend achiever would earn $9.49/share in 2013 and $9.68/share by 2014. In contrast, it earned $8.36/share in 2012. Currently, the stock is attractively valued at 14.20 times earnings and yields 4.30%. Check my analysis of Lockheed Martin.

General Dynamics Corporation (GD), an aerospace and defense company, provides business aviation; combat vehicles, weapons systems, and munitions; military and commercial shipbuilding; and communications and information technology products and services worldwide. The company derives over 66% of revenues from US government. Approximately 13 percent of revenues are derived from international defense the remainder is from commercial customers. General Dynamics  has raised dividends for 22 years in a row. Over the past decade, it has managed to boost distributions by 13%/year. The outstanding shares from decreased from 398 million in 2003 to 353 million in 2013. Analysts expect that this dividend achiever would earn $6.96/share in 2013 and $7.23/share by 2014. In contrast, it earned $5.65/share in 2012. Currently, the stock is attractively valued at 12.60 times forward 2013 earnings and yields 2.60%. Check my analysis of General Dynamics.

Raytheon Company (RTN), together with its subsidiaries, provides electronics, mission systems integration, and other capabilities in the areas of sensing, effects, and command, control, communications, and intelligence systems, as well as a range of mission support services in the United States and internationally. Raytheon  has raised dividends for 9 years in a row. Over the past decade, it has managed to boost distributions by 25.40%/year. The outstanding shares from decreased from 415 million in 2003 to 326 million in 2013. Analysts expect that this dividend stock would earn $5.66/share in 2013 and $5.95/share by 2014. In contrast, it earned $5.65/share in 2012. Currently, the stock is attractively valued at 13.20 times earnings and yields 3%.

Northrop Grumman Corporation (NOC) provides systems, products, and solutions in aerospace, electronics, information systems, and technical service areas to government and commercial customers worldwide. Northrop Grumman  has raised dividends for 10 years in a row. Over the past decade, it has managed to boost distributions by 13%/year. The outstanding shares from decreased from 368 million in 2003 to 238 million in 2013. The company has an open buyback facility to repurchase approximately 25% of outstanding shares by 2015. Analysts expect that this dividend achiever would earn $7.78/share in 2013 and $7.99/share by 2014. In contrast, it earned $7.81/share in 2012. Currently, the stock is attractively valued at 12.20 times earnings and yields 2.50%.

L-3 Communications Holdings, Inc. (LLL), through its subsidiary, L-3 Communications Corporation, provides command, control, communications, intelligence, surveillance, and reconnaissance (C3ISR) systems; aircraft modernization and maintenance; and national security solutions in the United States and internationally. Over 75% of revenues were derived from US Department of Defense and Government Agencies, while International Sales accounted for 19% of revenues. The remainder is generated from sales to US corporate customers. L-3 Communications has managed to increase dividends for 9 years in a row. Over the past five years, it has managed to boost distributions by 15.30%/year. The outstanding shares decreased from 127 million in 2007 to 91 million in 2013. The number of outstanding shares increased from 106 million in 2003 to 127 million in 2007, because the company has grown through acquisitions, paid for by stock and cash. L-3 Communications has an open buyback facility to repurchase approximately 20% of outstanding shares by 2015. Analysts expect that this dividend stock would earn $8.13/share in 2013 and $8.17/share by 2014. In contrast, it earned $8.30/share in 2012. Currently, the stock is attractively valued at 11.20 times forward 2013 earnings and yields 2.40%.

A company can only afford to maintain and increase dividends per share over time only through increases in earnings per share. Without earnings growth, the dividend can only grow to a certain level after which it would stagnate and lose purchasing power to inflation.

For companies like the ones mentioned in this article, a large portion of revenues are derived from the US Government or US Government Agencies. The problems with the US budget deficit are widespread. As a result, it is very possible that defense contractors would experience decreases or limits to the amount of weapons they can sell to their main customer. This could potentially lead to lower profits and dividend freezes or cuts.

Because most defense contracts are won after a competitive bidding, it might wise to acquire shares of several contractors such as Lockheed Martin, Raytheon, General Dynamics, Northrop Grumman, rather than focus on a single company. I am unable to determine which one would win the most revenues from the defense budget pile, which is why such an approach could be useful. In troubled times, I wouldn't be surprised to also see consolidations in the sector.

One positive is that companies have been able to repurchase a large portion of its stock over the past decade. A company which can consistently retire 1%-2% of shares each year, pays 4% yield and that can grow net income by 1-2%, can easily manage to grow distributions at a rate that can maintain purchasing power of the income. If the largest customer cuts their spending budget however, this yield could get axed as profitability suffers.  Either way, if a company generates so much cash flow that it is able to buyback a significant amount of outstanding stock at attractive valuations, and could continue doing so, it could provide decent returns to investors. Some notable buybacks include the ones from Northrop Grumman (NOC) and L-3 Communications (LLL), which could retire as much as 20 - 25% of outstanding shares within 2- 3 years. This could also provide room for dividend increases, even if overall sales and net incomes are flat.

However, US will always need to spend money on defense, given its role as a “world cop”. The world is continuing to be a hostile place, particularly in certain hot spots such as North Korea, Iran and a few of the countries that participated in the Arab Spring in 2011.

In the long-run however, (say 20 years from now), I cannot see anything else but increases in US government spending on defense. The world would still be a hostile place, and countries need to spend on defense simply to keep up with pace of technology. This means that if you buy today, you can still experience dividend cuts five years down the road, although chances are your distributions would recover within 10 years or so. This cyclical nature of dividend booms and busts makes relying on defense dividends riskier than relying on distributions from Coca-Cola (KO).

Surprisingly, some of the best times to acquire defense companies was right after the cold war ended in 1989. Other attractive times to buy defense companies occurred right after the official end of Vietnam war in 1975.

To summarize, the major bearish factor behind defense companies is the US Government spending situation in the next few years, and the need to reduce the budget deficit and curtail the growth of national debt. This could cause stagnating or decreasing military budgets. Since the major wars the US fought over the past decade are pretty much over, this could potentially affect profitability in defense companies.

The major bullish factors include cheap valuations, and the potential for a few of those companies to repurchase massive amounts of stock at these low valuations. If I were to invest in the sector, I would focus on the companies that reduce a large portion of shares outstanding. If net income can be at least maintained, the reduction in shares would lead to increases in earnings per share, which could also result in dividend growth.


Relevant Articles:

- General Dynamics (GD) Dividend Stock Analysis
- Lockheed Martin Corporation (LMT) Dividend Stock Analysis
- Two dividend paying stocks to consider today
- Three Stages of Dividend Growth
- Share Buybacks versus Dividends