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Why The Defense Industry Is a Great Shield for Your Portfolio

The Aerospace & Defense sector is offering a few sale opportunities right now.

I often have the feeling we forget about industrials. There is nothing sexy about them. There is often minimal stimuli to create hype on the stock market. Even worse, this sector is not seen as a source for high dividend yields. As many industries operate through unique economic cycles, there are always a few industrials for sale.

The Aerospace & Defense sector is offering you such opportunity right now. Due to their long-standing existence and packed with generous government contracts, they have built solid core businesses. Those who have survived the passage of time and found ways to evolve often make solid dividend payers.

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Today, we are looking at three of my favorite defense stocks!

Lockheed Martin (LMT)

  1. LMT has the size and scale to share its defense expertise around the globe.
  2. LMT has become THE defense company for the U.S. government and the go-to for fighter aircraft.
  3. Payout ratios are under control and LMT continues to reward shareholders handsomely.

Business Model

Lockheed Martin is the largest defense contractor globally and has dominated the Western market for high-end fighter aircraft since being awarded the F-35 program in 2001. Lockheed’s largest segment is Aeronautics, which is dominated by the massive F-35 program. Lockheed’s remaining segments are rotary & mission systems, which is mainly the Sikorsky helicopter business; missiles and fire control, which creates missiles and missile defense systems; and space systems, which produces satellites and receives equity income from the United Launch Alliance joint venture.

Source: LMT Q2 2021 investors presentation

Source: LMT Q2 2021 investors presentation

Investment Thesis

LMT now benefits from more generous international sales regulations. As geopolitical tensions continuously rise around the globe, Lockheed Martin is in a great position to offer its products to other countries. LMT counts on its F-35 fighter aircraft program and missile defense systems to grow in the coming years. The company enjoys a strong bond with the U.S. government and provides high-quality defense products. There are very few competitors in these markets and LMT is increasing its order backlog at a rapid pace. LMT is currently paying down its debt and showing stronger cash from operations. Even better, LMT keeps buying back shares every year. What’s not to like?

Dividend Growth Perspective

Screen Shot 2021-08-25 at 2.07.03 PM

The company has increased its dividend each year since 2004. It seems LMT is surfing through the perfect storm. As conflicts are increasing around the globe, Congress has accepted Lockheed Martin’s efforts to seek out international opportunities. This means the company could substantially increase its international sales. I expect LMT will not only grow its earnings in the coming years but its revenues as well. Shareholders can expect a high single-digit dividend growth rate along with continuing growth in the market value of the company.

Potential Risks

LMT exists in a semi-monopoly state, so it only has one big customer. Budget sequestration is always a possibility (budget defense slowdowns are expected in the coming years). After all, the company did show a lot of difficulty growing its revenues prior to the acquisition of the Sikorsky Aircraft helicopter division. It is unsure if LMT will be able to grow Sikorsky helicopter revenues in such a competitive environment. Even their F-35 program has been criticized lately. There is also a “new” player in town with the merger of Raytheon and United Technologies. Finally, LMT has a huge pension plan which weighs on the company’s balance sheet when the market goes into negative territory.

General Dynamics (GD)

  1. GD is ¾ a defense company and ¼ a business jet manufacturer.
  2. The company has increased its dividend at a strong rate over the past 5 years.
  3. Additional growth coming from global defense budget increases are an obvious growth vector.

Business Model

General Dynamics is a defense contractor and business jet manufacturer. The firm’s segments include aerospace, combat systems, marine, and technologies. The company’s aerospace segment creates Gulfstream business jets. Combat systems mostly produces land-based combat vehicles, such as the M1 Abrams tank. The marine subsegment creates nuclear-powered submarines, among other things. The technologies segment contains two business units, an IT business that primarily serves the government market and a mission systems business that focuses on products that provide command, control, computers, intelligence, surveillance, and reconnaissance capabilities to the military.

Source: GD website

Source: GD website

Dividend Growth Perspective

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GD has successfully increased its dividend each year since 2014. In early 2021, management demonstrated confidence in its business model and announced an 8% dividend increase. With both payout ratios under control (under 40%), strong margins, and a substantial backlog, GD should keep its aggressive dividend growth streak alive. We have reduced our dividend growth expectation to mid to high single-digit growth rates for the dividend discount model calculation.

Potential Risks

We must remain cautious about this type of business. GD mainly does business with large customers placing large orders. Many contracts are worth hundreds of millions of dollars. Should an order be canceled or delayed, the company’s financial performance could be strongly affected. GD’s growth will depend on the U.S. military budget, the business jet market (how fast it recovers) and its ability to integrate its most recent acquisition (CSRA) moving forward. Gulfstream order activity has recovered but is still far from pre-pandemic levels.

Northrop Grumman (NOC)

  1. Northrop Grumman has increased its dividend for over 13 consecutive years (since 2008).
  2. We expect a rising budget for unmanned aircraft in the coming years.
  3. It will be hard for the company to replicate their growth results in the future.

Business Model

Northrop Grumman is a defense contractor that is diversified across short-cycle and long-cycle businesses. The firm’s segments include aeronautics, mission systems, defense services, and space systems. The company’s aerospace segment creates the fuselage for the massive F-35 program and produces various piloted and autonomous flight systems. Mission systems creates a variety of sensors and processors for defense hardware. The defense systems segment is a mix between a long-range missile manufacturer and a defense IT service provider. Finally, the company’s space systems segment produces various space structures, sensors, and satellites.

Source: NOC Q2 2021 investors presentation

Source: NOC Q2 2021 investors presentation

Investment Thesis

NOC is a leader in the global security/military business. The company is basically a strong tech business with a focus on military products. NOC is also the leader in unmanned aircraft with the highest altitude and longest endurance products on the market. We think there will be a growing demand for this type of product. Since human losses are not very popular in politics, we expect a rising budget for unmanned aircraft in the coming years. NOC is also well positioned in the bomber and fighter market segments with its B-21 and F-35 programs. These programs will continue to drive growth for years. The company can also count on its acquisition of Orbital ATK (2018) and its technology services segment to boost its revenues going forward.

Dividend Growth Perspective

Screen Shot 2021-08-25 at 2.16.02 PM

NOC used to have a solid yield of 3.5%+ but it is now a stock that most income-seeking folks ignore. The problem is while the dividend grew significantly, the stock price exploded (triple digits during a 5-year period). Expect management to keep a high-single digit dividend growth rate. Even though management has been generous with shareholders, they still benefit from plenty of room to increase their payout as both payout and cash payout ratios are under 50%.

Potential Risks

Over 80% of NOC’s revenue is derived from the Department of Defense and other U.S. government agencies. We all have seen how this affected revenue in the past. We doubt NOC or any other defense contractor will be able to improve its margins once again if a similar situation happens. The company also put a lot of focus on cost-plus programs with lower margins, such as the B-21 and F-35. There is general concern about a budget sequestration in the future and this could limit NOC’s future growth. Following the spending due to the COVID-19 outbreak, the government will have to cut somewhere. Each military expense will be subject to review, and this could slow down military industry growth over the next few years.

Final Thought

There are still lots of uncertainties about how the military budget will grow in the coming years. However, this industry has proven in the past (notably the 2012 budget sequester) that it can quickly adapt and keep rewarding shareholders for their patience. Companies like LMT and NOC are trading at a PE below 15. They are part of the rare cheap stocks in this market. You have a chance to grab a few shares and enjoy a continuously growing dividend payment!

Cheers,

Mike Heroux, Passionate Investor & founder of Dividend Stocks Rock

P.S. Are you concerned by the current state of the market? I’m hosting a free webinar on What To Buy In This Overvalued Market? Know What to Buy, Know When to Sell. Save your spot here!

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**Please do your own due-diligence before investing in any stocks we discuss in this article**

I may hold shares of companies discussed in this article.

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