Defense Firms Await Cuts but Offer Premium Yields
NEW YORK (TheStreet) -- The massive defense sector is awaiting November's elections for massive budget cuts that could reshape its business for the next decade. For investors, however, it may not all be terrible news.
Since the beginning of June, the largest market cap defense contractors have seen their share prices jump more than 6%, in spite of amplified chatter about sequestration that would cut the defense budget by some $500 billion.
"Many of the programs that the large defense contractors are working on every day are programs that were contracted and paid for by prior year budgets," said Yair Reiner, a defense analyst at Oppenheimer & Co. "In any given year, the large defense primes are getting two-thirds of their revenue from contracts that were signed in prior years."
Lockheed Martin(LMT) , Boeing(BA) and Northrop Grumman(NOC) have seen shares climb 6.9%, 7.9% and 12.7%, respectively, since June 1, while General Dynamics(GD) has seen a slight dip of 0.56% in the same period.
Large-cap defense contractors may be on better footing than the doom and gloom of cuts would suggest.
Most traders who want to invest in companies like Lockheed, Northrop Grumman and others are looking at yields instead of equity appreciation.
"In context of where yields on treasuries are at historic lows, the relatively healthy yields of the defense primes are being valued at a premium," said Reiner.
If the state of the global economy continues to be jittery, defense could be a safe-haven investment. Reiner said continued poor yields on Treasuries have caused investors to value dividends at a premium.
The Sequestration Transparency Act could force the Department of Defense to rework those contracts signed in prior years if it triggers on Jan. 1, 2013.
There's little consensus inside Washington and among analysts as to what exactly will happen, but few people seem to think the extreme scenarios -- full sequestration or no cuts whatsoever -- will ensue.
"We think that the most likely outcome will be cuts to the plan in the $100 billion to $400 billion range over the next 10 years, with a vast majority of the reduction coming after year five," Robert Stallard, an analyst at RBC Capital Markets, wrote in a research note.
Stallard's research predicted that in the worst-case scenario defense primes could see earnings per share drop on average about 10%.