Delaware Dividend Income Fund co-manager Nik Lalvani says the beaten-down defense contractor is ready to launch.
By Scott Medintz, contributor
FORTUNE -- The Delaware Dividend Income Fund (DDIAX) is idiosyncratic, mixing large-cap dividend stocks with REITs and convertible and high-yield bonds to earn an average of 6.1% annually over 10 years. Today, says co-manager Nik Lalvani, 36, "we think the best equity-like returns are actually in equities." After all, the U.S. stock market has been the world's worst-performing over the past decade, and large caps like Raytheon were laggards. Here's why Delaware has been buying its shares.
1. Investors are too bearish on defense stocks
With the expected winding-down of the wars in Iraq and Afghanistan, says Lalvani, the market is anticipating a steep decline in defense spending. But the war on terror and other regional conflicts haven't diminished. If anything, he maintains, the geopolitical climate is getting more severe -- and that will limit the spending decline. His team expects flat to low-single-digit spending growth over the next few years. As a result, he says, defense industrials will hold up even if economic growth slows.
2. Raytheon is less vulnerable than its competitors
Raytheon (RTN) works on more than 8,000 defense programs through 15,000 contracts, and none accounts for more than 5% of its revenue. So if the U.S. Department of Defense cuts any single project, says Lalvani, the impact on the company should be minimal. Plus, the DoD has projected that more dollars will be allocated toward modernizing and improving existing defense technologies -- where Raytheon is well established -- as opposed to developing new ones.
3. International exposure adds another buffer
More than 20% of Raytheon's revenue comes from customers other than the U.S. DoD, the highest among major defense contractors, Lalvani says. Compared with U.S. defense budgets, spending among these customers (such as Saudi Arabia, Turkey, U.A.E., Taiwan, Japan, and several European allies) offers higher margins. This business is likely to remain relatively strong and should offset U.S. cuts. Raytheon's Patriot antiballistic missile system, for example, is in high demand internationally.
4. Even modest growth will boost the stock
Raytheon's price/earnings ratio reached into the 20s in the early 2000s. Lalvani doesn't expect it to approach those highs but says the current 9 is "way too bearish." Low to mid teens is more like it, once investors recognize that defense spending hasn't plummeted. He anticipates that revenue will grow modestly and earnings will increase at a mid- to high-single-digit pace, pushing the stock from about $50 today to a target of $80. The stock also offers a 3.5% dividend yield.
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