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5 Dividend Stocks Focused on Defense

Government spending is key to dividend growth for the sector

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L-3 Communications (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% per 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 per share in 2013 and $8.17 per share by 2014. In contrast, it earned $8.30 per 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.

Article printed from InvestorPlace Media,

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