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Defense Sector Stocks - 3 to Buy, 2 to Hold

March 08, 2012 | About:
The defense sector used to be a safe play for growth and dividends. There were two wars going on and the need for advancing battlefield technology fueled by nearly unlimited spending helped many companies do very well. Times have changed — one war is officially over and the second is ending and will be done by the end of 2014. Add to that the fact that America's military is cutting personnel and taking severe budget cuts and the outlook for this sector looks painful.

A strong defense company is one that separates itself from the pack: It focuses on highly specialized areas of military operations (such as Special Forces, unmanned drones, and cybersecurity). But more importantly, the company has to have a savvy lobbying team looking out for its interests. I believe investors in the defense industry too often focus on just financials. In this day and age, investors need to take into account the political climate as well. Only the companies with the best contacts in Washington can survive a prolonged period of budget austerity. Below, I will analyze five defense sector companies and point you to ones that will be able to make it through these tough times.

FLIR Systems (FLIR): In its release of earnings for 2011 FLIR's revenue was up 11% over 2010. The CEO commented that measures of operational efficiency and innovation helped increase margins and net income during this tough time. He also noted that it will position FLIR for future success.

FLIR's firm backlogged orders dropped about 15% over last year. Even with that outlook, the board increased the dividend 17% to the amount mentioned above. The outlook provided for 2012 is revenue growth of 0%-7% and net income growth of 16%-23%. This tells me that FLIR plans to continue increasing efficiencies and innovations to cutback on overhead and unneeded spending to help its bottom line. Its government business makes up about half of total sales, and about half of that is to the U.S. government.

I don't think FLIR will take as big of a hit from defense spending cuts, because military leaders plan to combat the troop reductions with an increase in Special Forces (SF) and unmanned drones. FLIR builds man portable systems for SF and tons of vision, targeting, and observation systems that can be mounted to drones. It's also working on marketing systems for use on personal cars, trucks, etc., to make night driving safer for people that frequently drive after dark.

FLIR is a good buy here; I think shares will see $30-$35 by the end of 2012. FLIR pays an annual dividend of $0.28 per share for a yield of 1% and has a payout ratio of 14%.

General Dynamics (GD): According to its most recent 10-Q, the SEC Division of Enforcement requested information on contracted accounted for using the percentage-of-completion method. This was in September 2011 and the company didn't say anything more about it. Later in the document it notes that the majority of revenues are recognized using this method. Anytime the SEC Enforcement Division requests documents a red flag should go up. Revenues and operating income or the quarter and nine months ended were relatively flat compared with the previous year.

I think if the drops from defense spending can be offset by the aerospace segment and commercial customers from IS&T segment, General Dynamics should be able to guard against an overall loss for the next few years. I think shares at $80 would be reasonable; the dividend is the play here. I think it will stay strong, or maybe even increase slightly to reward shareholders for staying loyal. It also offers an annual dividend of $1.88 per share for a yield of 2.7% with a 27% payout ratio.

L-3 Communications (LLL): There is a $2 annual dividend for a 2.8% yield with a 20% payout ratio. In July 2011, L-3 announced it is planning to spin-off an independent government services division in its third quarter 10-Q. About 76% of L-3's 2010 revenues came from the U.S. Department of Defense (DOD).

Due to the upcoming budget cuts, this has me very concerned. If the spin-off company takes the brunt of the loss then L-3 will be okay. L-3's website acknowledges the creation of a cyber solutions center. Cyber security is the other area that the U.S. DoD and other agencies will be increasing spending on in the near future. If L-3 can develop high quality solutions first, it can take control of a growing market and hopefully secure market share. Otherwise, I only see L-3 dropping somewhere near the $60 range by the end of 2012. I don't feel good about the dividend in that setting either. If you already own it, make sure to pay close attention to the annual report and year-end conference call.

Raytheon Company (RTN): Raytheon also offers an annual dividend of $1.72 per share for a 3.4% yield with a 40% payout ratio. In its latest earnings release, adjusted EPS for the full year were up 7% for 2011 over 2010. That increase came from operational improvements, share buy backs and early debt retirement. Sales for the year were down 6% but bookings were up almost 10%. Raytheon is already bracing for an impact from reduced government spending; it's looking for sales to remain flat or drop slightly for 2012. Raytheon generates a solid amount of free cash flow. Because of this I feel that its dividend is safe. I wish they would stop the buybacks and use that money for dividends to better repay shareholders, but it continues buybacks.

Regardless, Raytheon shares a good amount of business with entities outside of the U.S. government, such as Saudi Arabia, and the United Arab Emirates (countries that aren't in financial trouble, compared to the rest of the globe). I think it will continue developing the operating efficiencies to help it weather the storm until spending increases again. Like L-3 it is also growing its cyber security segment. I think Raytheon shares will remain flat though 2012; hold for the dividend.

SAIC (SAI): For 2011, revenues were up 2% and operating income was up 10% of 2010. In its 2011 annual report it reports the opening of its cyber innovation center. It also reports increasing revenue and income every year since at least 2007. SAIC is much less tied to DoD than the other companies in this article. SAIC does cyber security, electric smart grids, traffic control systems, etc. I think SAIC is overly beat up at this price and is the best prospect for growth of any of these defense companies. I think that because SAIC is least tied to wartime spending of these five. I like SAIC and see a rise to around $20 per share by end of 2012.

About the author:

Dividend King
I am primarily an investor interested in creating passive income streams through dividends. I focus on finding and analyzing dividend paying stocks, MLPs and REITs that are a good fit for income investors.

I practice Judaism and my faith is very important to me. I visit family in Israel once a year, but I am educated and work in the United States where I hold an MBA and a bachelor’s in English. I am a patient man, enjoy wine but am not a connoisseur, and I listen more than I speak.

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