The United States government is a large customer for many industries, but perhaps none more so than the defense companies. These giant corporations, Lockheed Martin (LMT) and Northrop Grumman (NOC), can earn virtually all of their revenue from government contracts. Clearly much of this spending is related to defense, but the actual services and good provided is varied and includes such things as space launch vehicles and the protection of sensitive computer networks.

Regardless of the actual end work, having one main customer is a big risk and one that each of the defense companies spells out in its annual reports. This risk has come to light with the recent budgetary wrangling that has been taking place on Capitol Hill. The action, or lack of action, in the Federal Government on deficit reduction plans has triggered a clause that was meant to spur compromise by making massive defense spending cuts mandatory. These cuts, which are now obligatory, are on top of already planned spending reductions.

The cuts will take effect in January of next year, unless something is done about them. That said, this date probably couldn’t be worse. In order for the cuts to be stopped, lawmakers would need to begin discussing the issue now, or at least very soon. However, it is an election year and rocking the political boat is frowned upon by both sides of the political spectrum.

The defense companies aren’t waiting around for the government to act. They are going on the offensive and making hay out of the fact that spending cuts will result in job cuts. While some in the government have been arguing about the preparedness of our military, a valid concern, the industry’s job cuts rhetoric is more likely to hit home with both politicians and the public, which has endured a painfully slow recovery from the 2007 to 2009 recession. Watching the tensions overseas, where the citizens of some nations have taken to the streets in protest because unemployment rates in their countries are well into the double digits (among other reasons), only highlights the pain of job losses on U.S. shores.

Wall Street hates uncertainty, and some of the defense contractor stocks are trading at levels that could make them tempting dividend investments for those with slightly more intrepid souls. For example, Lockheed Martin shares have recently been yielding over 4.5%; that is well above historical norms for this company and is roughly twice the median yield of all dividend-paying stocks Value Line covers. Moreover, its P/E ratio relative to the market’s is suggesting its shares are inexpensive.

The defense industry is large and varied, filled with companies that both compete and cooperate at the same time, and acquisitions are common. Normally, the largest players swallow up smaller participants that can expand their offerings or allow for cost cutting. Income-oriented investors are likely to be best served by sticking to the giants and leaving the small fry to more aggressive sorts.

Some names that income investors might want to keep an eye on include:

General Dynamics Corporation

General Dynamics Corporation (GD) operates in four divisions: Aerospace (19% of 2011 sales); Combat Systems (27%); Marine Systems (20%); Information Systems and Technology (34%). The U.S. Government accounted for 69% of total revenues while foreign sales were 19%. Web: www.generaldynamics.com.

Lockheed Martin Corporation

Lockheed Martin Corp. provides a broad range of products and services to the world's governments and commercial customers. Areas of concentration include space and missile systems, electronics, aeronautics, and information systems. In 2011, 82% of sales were to the U.S. Government. Web: www.lockheedmartin.com.

Northrop Grumman Corporation

Northrop Grumman Corp. is a leading maker of airborne systems; a designer of electronic warfare items; makes space systems and provides advanced information systems. The U.S. Government accounted for 90% of total sales in 2011. Web: www.northgrum.com.

Raytheon Company

Raytheon (RTN) represents the December 1997 merger of (old) Raytheon Co. and the defense electronics business of Hughes Electronics Corp. This corporation is a global provider of ground-based air defense systems, air intercept missiles, airborne and ground-based radar systems, communication and other military systems, and is an important producer of electronics-based aerospace and defense products and systems. In 2011, sales to the U.S. Government were 74% of the top line. Web: www.raytheon.com.

While it is true that the entire industry is facing the fiscal knife, the above companies are large and financially stable. They are highly likely to survive any cutting that takes place—if such endeavors evolve. Moreover, they may benefit over the longer term if smaller players are weakened to the point where they can be profitably ingested. There are risks, however, and near-term volatility is likely as the drama plays out. But for income investors looking for relatively inexpensive issues with solid dividends and decent yields, defense might be a good offence—particularly if the defense contractors are making a concerted attempt to fight back. 

At the time of this article’s writing, the author did not have positions in any of the companies mentioned.