Government Belt Tightening Creating Opportunity for Defense Stocks

The election is history and now we have a Democratic president amid fiscal cliffs, deficits, national debts, and a weak economy. Cutting defense spending is anathema to the public consciousness, or maybe just the political consciousness. The reasons I do not like that knee-jerk reaction to defense budget cuts actually deals more with military and technological superiority instead of some misplaced desire for everyone to get along. The defense budget is always “frozen” instead of cut. Any cuts or freezes will hurt defense stocks in the short-term, but it might force them to innovate. Innovation benefits everyone, and will eventually benefit the share price.

I like cuts because I think it is like any other company making cuts. Cut the stuff that does not work, or has been surpassed by new technologies. Governmental organizations even more that private ones are subject to inertia. Projects just continue on even if they become irrelevant. Sometimes this has to do with the culture, and other times it is just bureaucratic momentum.

A fictional example of a culture that runs contrary to the reality of the situation can be seen in the fantastic book World War Z. In that book after the U.S. was pushed back to the western states, an initiative was put in place to build an army including all the war materiel that will be required. When the person in charge mothballed certain projects there was much resistance. A notable example was abandoning stealth planes, which was opposed by many Air Force generals. However, that was just a reflexive reaction. The enemy in this case did not think, fly, or use radar. Stealth planes were not a good place to allocate limited resources.

Examples this extreme are not found in the real world, though there are some in the same vein, such as Vietnam being fought as a conventional war. Cutting a few billion from the budget to allow you to inject it back into new projects is not a bad thing. Reallocation can and probably do happen while the total value of the budget remains the same, but cutting it would allow the organization to progress as if there was no more money to be had. That gives you a true free hand. I know it might seem overly simplistic, but ask yourself why companies close down business units while creating new ones instead of repurposing them. It is because you cannot break through the entrenched interests and processes that have taken root.

Weapons Are a Lucrative Trade

If you survey the recent news for Raytheon (NYSE: RTN), contracts are being won from international customers and some from the U.S. military. It seems that international contracts are bigger than the U.S. ones, but I am sure not all things are made public. The importance of U.S. contracts cannot be understated. It is well known that the U.S. spends the most on defense by a wide margin. If that source is drying up or even remaining stagnant the entire industry could see poor results. We are not going to know everything until the cliff is averted and a budget comes out, and at most I expect the can to be kicked down the road. Guidance far into the future is limited from the U.S. government.

With all that in mind, we should evaluate using a conservative outlook on U.S. spending. However, other countries might continue making upgrades and buying new systems. That is where innovation comes in. These countries say that they cannot buy 100 mediocre systems for $5M a piece, but they can buy 10 awesome systems for $10M a piece. In terms of firepower, both can get the job done and the 100 might get it done better, but countries are limited by their budgets.

The contracts for Raytheon are too many to get into, and I would rather just consider the entire picture. Earnings per share have been growing for the last few quarters, and have been on an overall uptrend for the last five years, with $5.79 as the most recent EPS diluted TTM. Other factors such as cash and debt look good. The profit margin of around 8% are in line with the past. A larger margin would be nice, but it is understandable considering contracts go to the lowest bidder. Companies have an incentive to pass on any savings from cutting expenses down to customers. The profit margin was the only thing that furrowed my brow until I really thought about it.

I like the 3.50% dividend yield, which has been increasing for the last few years. Since the stock is very near its 52-week high I would wait for something to take it further down. The gap between the 52-week high and low is narrow so you are not looking for a breakdown. I also do not expect a rapid breakout. I would hope that uncertainty over U.S. policy will take its toll on stocks and provide a great entry into an appreciating stock with a solid dividend. The stock is not as high as it was five years ago, but the last three years good on average. The company is fortifying itself against U.S. revenues shrinking by looking internationally. If the U.S. can sort out its problems, then the company will be poised to gain on both ends, and revenues should appreciate. For now, assume the U.S. will be problematic for some time.

Air Superiority is Important

English: CF-1 Flight 32. First C-model flight for Lt Cdr Eric Buus. Local area over Chesapeake and RTB to Runway 14 at PAX on 11 Feb 2011. Eric “Magic” Buus flew the F-35C for two hours, checking instruments that will measure structural loads on the airframe during flight maneuvers. (Photo credit: Wikipedia)

Much of that analysis applies to Lockheed Martin (NYSE: LMT) as well, and that company yields an even better dividend with a 5% yield with a history of growth. The debt-to-equity ratio is scary at 2.672, but it was at 6.454 last year. It is still above its normal ratio around 1.3. It is somewhat understandable considering that Lockheed has more large-scale production like the transport planes and fighters. That means a larger, more expensive manufacturing base. Lockheed almost makes weapons like Raytheon, but that is not what it is primarily known for. Lockheed has been no slouch about getting contracts. Air Forces around the world have planes that work and can be kept in the air with proper maintenance. In times of belt-tightening I would go with the weapons maker. If I were running ancient Rome and had the option of armored personnel carriers with no weapons for all my legions or WW2-era rifles for every legionary and more than ample ammunition, I would take the guns if they were the same price. When you absolutely have to choose offense is the way to go, since you cannot stay on defense forever.

If you really did want guns and planes, I would take Raytheon and add some The Boeing Co. (NYSE: BA). Any company that starts with “the” deserves some respect. Actually, the mix of military and civilian aviation makes it a nice complement to Raytheon. I would never want too much exposure to defense, and I feel like Lockheed is more defense, while Boeing is more civilian. That might seem arbitrary, but I have never flown in a Lockheed plane. I think the Dreamliner and all the commercial operations will insulate Boeing from government spending headwinds. Obviously any defense related projects are subject to these concerns, but commercial aircraft removes some of that risk. The design has a long life with upgrades, and I am sure the company will hammer out any issues. Commercial aircraft is management’s focus, and I think that is right on the mark. Lockheed does have its impressive dividend yield, but I prefer the mix of Raytheon and Boeing.