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Seven Ways to Profit from the GOP's Pledge to Sustain Defense Spending

Investors typically hate it when a stock bombs, but there are also times when bombs can make for good investments – and right now could be one of them.

With the Republicans seizing control of the U.S. House of Representatives and making gains in the Senate in Tuesday's mid-term elections, it now seems far more likely that the GOP will be able to honor its pledge not to cut defense outlays as it seeks to rein in discretionary government spending.

For the near term, that means the proposed 2011 U.S. defense budget of $708 billion should get through Congress relatively unscathed. It's also likely there will be less pressure to cut military spending in the budget battles for upcoming years – and that could bode well for most of the major U.S. defense contractors.

That's not to say the entire defense sector deserves a blanket "buy" recommendation, since some top contractors still face cutbacks on behind-schedule or over-cost projects such as the new F-35 fighter jets. The developers of major weapons systems, like defense-sector leader Lockheed Martin Corp. (NYSE: LMT), which had $11.904 billion in government contracts in 2009, also will face demands for greater efficiency under a new purchasing policy being implemented by Secretary of Defense Robert M. Gates.

The new policy calls for issuance of fixed-price contracts that would make the contractor, rather than the government, responsible for a major portion of any cost overruns. The Defense Department also would give preference in the bidding process to companies that have shown a history of cost-containment. Gates believes this change could produce savings of up to $100 billion over the next five years.

Recognizing the potential lost revenues defense contractors could face from this policy change, as well as the possibility of increasing military budget cuts in spite of the Congressional power shift toward the GOP, the market has discounted the price of a number of top defense stocks, making them attractive at current levels.

Following are seven potential defense-sector investments with which you can arm your portfolio.

Arming Your Portfolio with Defense Contractors

Northrop Grumman Corp. (NYSE: NOC), recent price $65.28 – NOC currently ranks second among defense companies with $9.324 billion in 2009 contracts (totals for 2010 are still building). However, unlike No. 1 Lockheed Martin, which reported drops in revenue and profit in the third quarter, Northrop said on Oct. 27 that its fortunes had improved from a year ago.

The company announced revenue of $8.7 billion, up 4%. Third-quarter profit totaled $497 million, or $1.67 per share, compared to $490 million, or $1.53 per share, in the same quarter last year. Both figures beat analysts' expectations, and Northrop hiked its full-year EPS forecast a range of $6.85 to $7.00, compared to prior guidance of $6.60 to $6.80. The stock is up about 17% on the year – nearly doubling the Standard & Poor's 500 Index's year-to-date gain of 9% – and the improved outlook could provide the impetus needed for Northrop stock to surpass its 52-week high of $69.80, set in late April.

Raytheon Co. (NYSE: RTN), recent price $47.99  – Raytheon's primary business isn't making weapons, but it still ranks No. 4 on the list of defense contractors, providing the military with both software and equipment for command and control operations, guidance systems, communications systems, intelligence, cyber-security and mission support. The total value of RTN's defense-related contracts in 2009 was $6.187 billion. The company is also a major supplier of equipment to the Department of Homeland Security

Raytheon just reported third-quarter revenue of $6.3 billion and adjusted earnings of $1.36 per share, up from $1.25 a year ago. Trailing 12-month earnings stand at $4.12 a share, the price/earnings (P/E) ratio is 10.13, and the dividend of $1.50 per share provides a yield of 3.1%. The company also is a bit of a cash cow, with $2.38 billion in cash on hand and a free cash flow of $2.25 billion. The stock has lagged the rest of the defense sector and is well below its mid-April high of $60.10, but it could be poised for a rebound based on several recent buy ratings from leading brokerages.

General Dynamics Corp. (NYSE: GD), recent price $68.93 – GD ranked fifth among defense contractors in 2009 with $4.73 billion in contracts. That number is likely to rise in 2010 thanks to an assortment of new projects, including several for work on advanced submarine technologies and upgrading of systems on other U.S. warships (the company was awarded $210 million in new contracts for submarine work in just the past week).

General Dynamics just reported third-quarter net income of $966 million on revenue of $8.01 billion, both up sharply from year-ago levels. Earnings per share for the past 12 months stand at $6.47, giving the stock a P/E of 10.60, and the $1.68 dividend provides a yield of 2.44%.

Computer Sciences Corp. (NYSE: CSC), recent price $49.67 – CSC doesn't provide the Defense Department with weapons, but it provides the computer systems that make many of the DoD's weapons work, as well as the systems that keep the business of managing the nation's defense operating smoothly. The company had $2.221 billion in defense contracts in 2009, ninth among major contractors. The company also won $3.2 billion in new contracts from all sources, including non-governmental, in its fiscal first quarter, which ended June 30.

Earnings for that quarter were 91 cents a share, exceeding analysts' expectations. Second-fiscal-quarter results will be reported Nov. 10 and are expected to be in line with forecasts, en route to an annual revenue figure of $16.8 billion to $17.2 billion.  CSC's trailing 12 months earnings were $5.33 a share, giving it a P/E of 9.32. The dividend of 60 cents represents a yield of 1.21%. The company is also fairly rich in cash, with $2.44 billion on hand and a levered free cash flow of $855.6 million for the past year.

KBR Inc. (NYSE: KBR), recent price $26.05 – KBR took in $4.545 billion from the DoD in 2009, the bulk of it for engineering and construction services at military bases and other defense facilities. The Houston-based company also has a major liquefied natural gas operation that helped offset a slight decline in military revenues in the first part of 2010. Overall, KBR reported third-quarter income of $97 million, or 62 cents a share, on revenue of $2.5 billion. The revenue was down slightly from the year-ago quarter, but earnings were up from 45 cents a share. For the past 12 months, KBR had earnings of $2.01 a share, giving it a P/E of 12.9. The dividend of 20 cents a share yields 0.77%.

If you'd like to dabble in defense issues for a lower price, one other company you might take a look at is GenCorp Inc. (NYSE: GY), recent price $4.90. This aerospace and defense company – and its primary subsidiary, Aerojet-General – has been a pioneer in the development of critical propulsion technologies for both the U.S. military and the space program. Aerojet is the only domestic supplier of all four propulsion types – solid, liquid, air-breathing, and electric – and its products are used in missiles, maneuvering systems, launch vehicles, spacecraft and satellites. It also supplies Boeing, Lockheed Martin and Raytheon in addition to the DoD and NASA. Trailing 12-month earnings were $121.4 million, or 48 cents a share, on revenue of $795.4 million, both up from the prior year. GY pays no dividend.

All of the above-listed companies have added advantage of garnering a significant portion of revenues from areas outside the defense industry, which should provide a moderate price cushion should the new Congress find defense cuts have to be included in order to meet deficit-reduction goals.

If you don't want to risk the possible loss of a major contract by a single defense company, you can gain some added diversification by putting your money into one of several defense-oriented exchange-traded funds (ETFs). Two of the leading ones are:

iShares Dow Jones U.S. Aerospace & Defense Fund (NYSE: ITA), recent price $58.06 – This fund seeks to track the performance of the Dow Jones Index of the same name, holding the stocks of manufacturers, assemblers and distributors of aircraft and aircraft parts, as well as producers of defense components and equipment, such as military aircraft, radar facilities and weapons. Distributions over the past year have provided a yield of 1.18%.

PowerShares Aerospace & Defense (NYSE: PPA), recent price $18.46 – PPA tries to mirror the price and yield of the SPADE Defense Index, which tracks a group of companies involved in the development, manufacturing, operations and support of U.S. defense, homeland security and aerospace operations. The fund's portfolio is rebalanced quarterly and reconstituted annually. The fund has a history of declaring regular distributions, most recently providing an annual yield of 1.17%.

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