Defense contractors have taken a major beating in the market this year, and many defense stocks currently sport price-to-earnings (P/E) ratios near five-year lows.
Share prices have declined because of fears surrounding potential defense spending cuts. With the wars in Iraq and Afghanistan winding down, President Obama has proposed $400 billion to be cut from the defense budget during the next 10 years. At cuts totaling $40 billion a year, this works out to roughly 6% of next year’s defense budget of $571 billion. And more cuts could be on the horizon.

Certainly any cut in defense spending is negative for this industry, but I think, for at least some of the defense stocks, downside risk is not nearly as severe as their current valuations suggest. Their current low valuations create buying opportunities. Several defense stocks offer growing dividends and yields rich enough to entice even risk-adverse income investors.

Here are two defense stocks I especially like because of their strong cash flow, reliable dividends and declining exposure to U.S. defense spending cuts..

1. Lockheed Martin (NYSE: LMT)
Yield: 4%
Lockheed Martin is the world’s largest defense contractor and currently derives about 65% of $45.8 billion in annual revenue from U.S. Department of Defense contracts. Lockheed’s areas of expertise are unmanned aircraft and surveillance systems, which many defense industry experts think are the areas least likely to be impacted by budget cuts. The company is also pursuing non-military applications for its technology in satellite tracking and high-level data security.

While top-line growth may slow after budget cuts, Lockheed is a profitable company and is likely to remain so. The company posted 11% growth in earnings per share (EPS) to $2.14 in the second quarter of fiscal 2011, up from $1.92 a year earlier. Analysts look for earnings growth averaging 10% a year in the next five years — even in light of the expected budget cuts. Lockheed is aggressively cutting costs and recently trimmed 600 management-level employees from its workforce.

Lockheed is diversifying its sales mix by pursuing foreign military contracts. The company is currently awaiting approval from Congress for a multi-billion dollar weapons sale of F-16 fighter jets to Taiwan, and last month the company began delivering F-16 jets to Morocco and MH-60 helicopters to Thailand under long-term contracts. And with cash totaling nearly $11 per share, Lockheed has plenty of money to fund complimentary businesses. Last month, the company expanded its non-military IT business by purchasing QTC, which is the largest provider of outsourced medical evaluation services to the U.S. government and Department of Veterans Affairs.

Lockheed pays out just over $1 billion in dividends each year, which is easily covered by annual cash flow exceeding $2 billion. The company’s dividend grew 19% last year to a yearly rate of $3.00 and has increased 20% a year in the past five years. Lockheed is committed to returning 50% of cash flow to investors through dividends and share repurchases. The company has repurchased $2 billion of its own stock for five years in a row, which supports EPS growth and the share price. Right now, Lockheed shares are trading at a P/E multiple of about 9.3 (which is a five-year low) and yielding 4.1%.

2. Raytheon (NYSE: RTN)
Yield: 4%
Raytheon’s areas of expertise are defense electronics, missile systems and homeland security. The company generates about $25 billion in annual sales. Although budget cuts will hurt most defense contractors, Raytheon may actually benefit, since it is likely that spending in certain areas such as “retrofitting” or updating existing weapons with new electronics will increase. This is an area where Raytheon leads its competitors.

The company also benefits from rising sales to U.S. allies in Asia. Pakistan and India are important customers, but Raytheon is also a major weapons supplier to Saudi Arabia. Saudi Arabia has the world’s second-largest defense budget relative to gross domestic product, spending about 10% on defense (the United States is No. 1) so it will likely increase spending in response to rising turmoil in the Middle East this summer.

Raytheon’s EPS more than doubled in the fiscal 2011 second quarter to $1.23, from $0.56 a year ago. Analysts forecast long-term earnings growth of 9% a year. Raytheon consistently generates $2 billion in annual cash flow, but pays out just $540 million a year in dividends, which leaves a large cushion for dividend growth. This company has been paying a cash dividend since 1964 and has raised payments 11% a year for the past five years. The last dividend hike was by 15% in April to an annual rate of $1.72. Like Lockheed, Raytheon is stepping up share repurchases. So far, in 2011, the company has repurchased $625 million of its own stock. Share repurchases totaled $1.45 billion last year.

Raytheon’s share price fell 10% in July after the company modestly lowered the high end of full-year sales guidance, and the stock appears bargain-priced at less than eight times earnings. The stock yields about 4%.

Risks to consider: My analysis assumes defense spending cuts totaling roughly $40 billion a year, but actual cuts could be higher, which would make it more difficult for these companies to offset lost sales. Defense contractors also face risk from cost overruns on fixed price contracts. Lockheed has experienced cost overruns on its F-35 fighter jets, which strain operating margins. However, as I said earlier, I think these two contractors in particular have the wherewithal to come through these scenarios in relatively good shape. 

Action to take–> My top pick is Raytheon because of its expertise in retrofitting, an area least likely to be affected by spending cuts, but Raytheon and Lockheed Martin are attractive based on current low valuations, safe, growing dividends and attractive yields.