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Broader Tax Debate Could Spare Most Defense Investors

Nov. 30, 2012 - 03:53PM   |  
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As negotiations continue on potential sources of revenue for the U.S. government, and Congress seeks to avoid the combination of tax increases and budget cuts set to take effect next year, one subtle change could alter investment in defense companies.

The federal government has taxed dividends, regular cash payments to shareholders, at a 15 percent rate in recent years. That’s set to change with the expiration of the Bush tax cuts and the rate more than doubling to 39.6 percent. Agreement on a compromise appears elusive.

And while the climb will impact all publicly traded companies, the defense industry, which has increasingly leaned on dividends as a draw for investors, faces questions about its dividend-heavy strategy.

From 2006 through the end of 2011, top defense contractors increased their dividends by 71.5 percent, from an average of 16 cents per share per quarter to 28 cents, Defense News research found.

While some have expressed fears that increased taxation on dividends might drive investors away, companies are saying they don’t anticipate problems. The high percentage of defense stock owned by institutional investors and employees who are handling 401(k) funds shields the stock from the taxation question, as 401(k) taxation is deferred.

“As I talk to investors, and obviously employees are all in 401(k)s, most of them are not concerned about taxes on dividends,” said Bruce Tanner, Lockheed Martin’s chief financial officer, at a conference hosted by Credit Suisse Nov. 29. “Most of them are after yield. If I look at the population in general of ownership of our shares, some 29 percent, at least as we look at the share ownership, is held by yield investors. And those folks who we talk to frequently tell us that they’re much more interested in yield and they’re not as concerned about taxes.”

As a result, Lockheed is not changing its plan to produce high dividends, Tanner said.

“We don’t see a major shift, even with the potential increase in dividend taxes that is being discussed going forward.”

The potential impact was recognized early during the budget debates, said Byron Callan, a defense market analyst with Capital Alpha Partners.

“This has been known every since the fiscal cliff came into view, and companies have decided to proceed when it comes to dividends,” Callan said. “Whatever the advice is, it’s not going to cause them to change their guidance.”

Callan said that because the market as a whole will face the same potential tax increases, defense won’t be singled out.

“It’s all relative in the market,” Callan said. “It’s every dividend sector, not just defense.”

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