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Lacking Options, Big Firms Boost Dividends

Dec. 19, 2011 - 03:45AM   |  
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With few appealing acquisition targets and little Defense Department guidance about potentially fruitful lines of internal R&D, many U.S. defense companies have been doing something else with their accumulated cash: boosting dividends and buying up their own stock.

Defense News looked at 23 companies on the annual Top 100 list that are based in the U.S., are publicly traded, issue dividends and earn more than 10 percent of their revenue from defense. Among those companies, the average dividend payout rose from about 16 cents per share in the first quarter of 2006 to 28 cents per share today. That's a 71.5 percent climb.

For the top seven on the list, the increase was even greater, rising from an average of about 24 cents per share to 54. That's up 119.6 percent. Leader Lockheed Martin's dividend increased 233 percent.

Led by these top firms - besides Lockheed, they include Northrop Grumman, Boeing, General Dynamics, Raytheon, L-3 Communications, and United Technologies - the defense industry dividend yield was several times the average for the S&P 500 over that period.

The dividend growth, which continued even after defense stock starting declining in late 2008, has been a strategic move to attract investors when stocks aren't climbing, said Heidi Wood, a market analyst at Morgan Stanley.

"In a defense down cycle, defense is a sexy utility," Wood said, comparing the firms with unglamorous utility stocks that generally offer minimal growth but steady dividends.

Defense CEOs have balked at the comparison, but Wood says, "If you can't give big topline growth, why would anybody invest in defense?"

A larger market shift toward income investment strategies, which value stock primarily for the cash paybacks rather than rising value, means that defense companies needed to find a way to appeal to a broader market, Wood said.

"The judges have changed from being growth portfolio managers to being income portfolio managers," she said. "They want to see income. The only appeal that defense has in a down cycle is that they're throwing off lots of cash."

Moreover, there's not much better to do as revenue and profit continue to grow, yet the acquisition environment has not been very appealing, said Ron Epstein, market analyst for Bank of America.

"There haven't been that many opportunities," Epstein said. "If you have a couple billion bucks on your balance sheet, what else are you going to do with it?"

Accumulating cash can worry investors, he said.

"A big fear of investors is that the companies were going to do something not smart with cash."

Cord Sterling, vice president of legislative affairs at the Aerospace Industries Association, said giving money directly to investors is the smartest thing companies can do while the return on any capital investment is so uncertain. He pointed to the recent failure of the congressional "supercommittee," which is set to trigger an extra $510 billion in DoD spending cuts, on top of the $480 billion over the next 10 years already cut from the Pentagon's budget.

"You've got to decide, from your earnings, am I going to invest that in the next generation bomber? Submarine? The next-generation fighter? The next-generation missile? ... Where you don't know if DoD's even going to have a new submarine, a new ship, a new fighter aircraft, a new bomber a new missile," Sterling said. "You have no idea, because they've got a 20-percent budget pressure on them."

Buybacks Come Back

Not only have dividends risen sharply in the past six years, but defense companies have been returning a large amount of capital to stockholders through buybacks for nearly a decade.

Buybacks gained traction after Sept. 11. Along with stock prices, such purchases peaked in 2008, when the 23 companies analyzed by Defense News spent more than $17 billion to buy their own stock.

The following year, the number plummeted to around $7 billion, but has since risen to nearly 2008 levels by the third quarter of 2011.

"Through most of the defense upturn post Sept. 11, there was a huge focus on share buybacks. In '07-'08, those were all at prices well above current prices, and I don't know if it had the result that companies might have thought," said Sam Pearlstein, an analyst with Wells Fargo. "Looking in the rearview mirror, many of the repurchases in 2007 and 2008 were at prices well ahead of today's prices."

While defense spending cycles rarely follow the fortunes of the commercial market, Loren Thompson, head of the Lexington Institute, said defense companies with large commercial divisions were still hit by the 2008 recession and may have been forced to choose between dividends and buybacks.

"Although investors like buybacks, they like their dividends more," Thompson said, "and if you had to make a choice between cutting the dividend and buying back the stock, almost always the management would favor maintaining a dividend. So with sales and probably profits softening, the logical move for a company exposed to the recession would be to put off buybacks in order to maintain a dividend."

Top defense contractors that earn more than half their income from the civilian sector cut their buyback programs more dramatically than those more closely tied to the Pentagon. Boeing, which does about half its business on the commercial market, cut buybacks from almost $3 billion in 2008 to a mere $50 million in 2009. But Lockheed Martin, which is almost exclusively dependent on defense contracts, cut its buyback program by about a third between 2008 and 2009.

Analysts also pointed to a wait-and-see approach to the declining market in 2009 as dictating buyback policy. While stock buybacks can affect stock analysis by manipulating earnings per share - essentially, reducing the number of shares and improving the metric even if earnings remain flat or fall - investors do not look favorably on efforts to prop up prices during a steep decline.

"You don't try to catch a falling anvil; you wait until it hits the ground and then you get back in," Wood said.

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