It's safe to say that Lockheed Martin's (NYSE:LMT) sailed through the past year with flying colors.
Over that time, this defense stock's picked up more than 40%, rewarding investors handsomely. For shareholders, however, one of Lockheed's biggest draws is its 3.2% dividend yield. It's an added piece of security for investors thinking about the big picture, especially as defense budgets in advanced markets -- particularly at the Pentagon -- come under fire.
But is that dividend in danger? Pressure has mounted on sales across the defense sector, with even giants such as Boeing (NYSE:BA) and Raytheon (NYSE:RTN) feeling the heat. Can Lockheed investors count on this strong dividend yield for the long term, or should you ground this high-flying defense stock?
Defense budgets on the downswing
In a purely financial sense, Lockheed's dividend looks to be in good hands. Its dividend payout has been raised every year since 2003. A dividend payout ratio of 51% still offers Lockheed plenty of flexibility in continuing to raise that payout in the near future, and the company's producing strong cash flow. Indisputably, those factors bode well for the dividend's future.
However, there's more than just financial numbers to look at when considering this top dividend. Lockheed's managed to keep its operating income on the upswing as of late -- in its first quarter, the company grew that mark by more than 6% year over year. But those gains have come largely from cost-cutting moves. It's been a similar story around the industry: Raytheon in its first quarter boosted its operating income primarily by slashing its costs of sales by nearly 10% year over year, overcoming falling revenue. In the long term, however, Lockheed and other defense giants will need more than just cost savings to keep profits rising.
Unfortunately, the defense industry's anything but a growth haven right now. The market's long-term concerns have placed Lockheed's sales and future dividend raises in jeopardy.
The U.S. defense industry's responsible for the majority of most major defense contractors' revenues and accounted for 41% of global defense spending in 2011, according to a report by Deloitte.
Yet the Pentagon's budget is scheduled for a huge haircut through the rest of the decade: The Department of Defense requested $495 billion in its base budget for 2015, down more than 6% from 2010's base budget of $530 billion. Already, the drawdown of Western defense budgets has taken its toll on the industry: According to Deloitte, global sales at top defense companies declined fell by 1.3% in 2012 and 1.9% in 2011.
While there are opportunities for growth abroad, particularly in Asia and the Middle East, defense budgets in those regions still trail the U.S.'s significantly – and Lockheed, along with other top defense contractors, have yet to pivot significantly toward overseas markets. Raytheon, one of the better-positioned defense contractors, has boosted international sales up to 27% of total revenues, but the company's still reliant on more than two-thirds of total sales to the DOD. That's a major liability if the Pentagon continues to draw back its budget in coming years.
More pain could be on the way: 100% of aerospace and defense executives surveyed in a late 2012 study by McKinsey projected further ongoing worldwide defense budget drawbacks, particularly in North America. Worse, the Department of Defense's current projections of base budget requests between 2016 and 2019 exceed limits imposed by the Budget Control Act, per the Center for American Progress. That means more cuts likely are on the way, and while the DOD's already aiming to slash active-duty troop counts to save some money, it's likely that more headaches are on the way for top defense companies.
For Lockheed and its dividend, that trend could mean trouble.
Will the F-35 backfire?
Lockheed's sales have fallen victim to tightening budgets already: Four of the company's five business groups lost sales year over year in the first quarter. Lockheed's aeronautics division, its top unit by revenues, was the lone area of growth -- and, disappointingly, the division's operating margin declined by 0.3 percentage points in that time.
That's a trend that's spreading across military aviation giants: Boeing's own military aircraft unit saw its operating margin shrink by more than a full percentage point in its first quarter, along with witnessing sales contract by more than 4% year over year. Overall, Boeing's defense, space, and security division revenues plunged by nearly 6% in the quarter.
The F-35 Lightning II program is the bread and butter of Lockheed's aviation aspirations, and so far it's reeled in big bucks for this defense titan and kept its dividend on course. Yet Lockheed only sports a backlog of 85 aircraft for production, including international orders. Concerns over the spiraling costs for the F-35 program have put pressure on its future, and with the DOD currently planning to order more than 2,400 of the aircraft, there's a distinct possibility that the Pentagon may cut back on its orders in the future to save money.
Lockheed's no stranger to this: The F-22 Raptor, Lockheed and Boeing's previous fifth-generation fighter, saw orders drawn down from an original 648 aircraft to 183.
It's not helping Lockheed's cause that the F-35's run into trouble as of late. Earlier this month, the DOD grounded the entire fleet of Lightning IIs for inspection, and while that's not terribly troubling on its own, the Pentagon's also suspended current talks for further F-35 acquisitions for now. It may be a small issue when the facts emerge, but it's one more hit for opponents of the costly program to tout.
That's not to say that the F-35's a doomed plane. The Pentagon's rallied around the fighter's multi-role nature and stealth systems, and with so much federal money already invested, Lockheed's likely on solid footing. But with tightening defense budgets already impacting the company's other business units, Lockheed needs the Lightning II to continue to fly high in order to keep investors satisfied -- and its dividend on pace for future growth.
Facing an uncertain future
Cost-cutting is enough to keep Wall Street happy in the short term for Lockheed and its strong dividend, but this defense giant will need to do more to keep its dividend on the right track for the long term. Its reliance on its aeronautics division for sales growth -- in particular, the F-35 program -- makes the company particularly vulnerable to the fickle nature of today's budgetary climate, especially considering its reliance on the U.S. government for contracts.
Still, Lockheed's size and sway in Washington makes this company a top pick in the defense sector. This stock's certainly showed no signs of surrendering to budget cuts so far. However, as the Pentagon draws down ongoing operations overseas and fiscal hawks on Capitol Hill look for pennies to pinch, Lockheed and other top defense contractors are facing an uncertain future. This dividend's safe for now, but for long-term investors, the future's no sure thing.
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Dan Carroll has no position in any stocks mentioned. The Motley Fool owns shares of Lockheed Martin and Raytheon Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.