This Defense Company Makes a Product the Pentagon Can’t Live Without

Military heroes typically are made of flesh and blood, but that’s all changing. For defense strategists, pilot-less aircraft outfitted with ultra-sophisticated sensors are a vital tactic in fighting the guerilla wars of the 21st century. These so-called unmanned aerial vehicles (UAVs) are the darlings of reformers in the Pentagon, and Raytheon (NYSE: RTN) is the leader in the field by virtue of its unparalleled expertise in sensor technology.

Simply put, UAVs are aircraft that fly without a human crew on board – which is why they completely rely on sensors. Many are armed with missiles and they’re seeing action in Iraq and Afghanistan.

Sometimes called pilot-less drones, the concept of UAVs isn’t exactly new. UAVs trace their origins to primitive remote-controlled devices that appeared as far back as 1916. However, UAVs are now undertaking increasingly sophisticated missions, including high-altitude surveillance and a hunter-killer role on the battlefield.

Raytheon, based in Waltham, Mass., is engaged in defense, cybersecurity, homeland security and other government services around the world. Its dominant presence in the sensor sector makes it one of the best-positioned companies among its large-cap defense brethren to capitalize on this specific industry.

Raytheon doesn’t build the actual UAV airframes; what it provides are the sophisticated sensors that make them work – the “guts” of these machines, if you will. The company’s future growth will be driven by this specialty.

The only potential downside to this investment play would be significant cuts in defense spending, particularly in UAVs, but that’s unlikely to occur. Many places on the planet remain wracked by strife. And despite budget deficits and recessionary economies, the world’s militaries won’t be financing their purchases with bake sales.

One aerospace consultancy estimates that UAV spending will more than double during the next decade, from current worldwide UAV expenditures of $4.9 billion a year to $11.5 billion a year, totaling more than $80 billion in the next ten years. Sensors account for about 50 percent of these figures.

The Pentagon’s 2010 military budget is $680 billion, more than all of the rest of the world’s military expenditures combined. In 2009, the Pentagon budget was $651 billion. These figures don’t even include many of the expenditures for the Iraq and Afghanistan wars.

And while the 2010 military budget slashes spending for ultra-expensive legacy programs such as the F-22 Raptor fighter jet, it boosts funds for UAVs. U.S. military forces plan to spend nearly $5.4 billion on UAVs in fiscal 2010, which begins in October, up +18.4% from the current year.

For beleaguered aerospace companies still grappling with the global economic downturn, this increased largesse is a lifesaver. For Raytheon in particular, it’s a boon.

The fast growth of the UAV market is being accompanied by soaring demand for UAV sensor technologies. Raytheon supplies the sensors on board Northrop Grumman’s Global Hawk high-altitude long endurance UAVs. The U.S. Air Force plans to buy five in the 2010 fiscal year.

The proliferation of subcontractors in the sensor market makes precise figures for market share difficult to pinpoint. That said, Global Hawk accounts for about 41% of the UAV market, which puts Raytheon in a dominant position. Raytheon’s major sensor competitors include avionics companies such as Thales, Elbit (Nasdaq: ESLT), Sagem, and BAE Systems. The fact is, UAV-sensor spending is dominated by a few large programs such as Global Hawk, with little left for the others.

Raytheon has a head start over its competitors because of its long heritage in the missile business. As the world’s largest missile maker, Raytheon possesses proprietary legacy technology that enables it to create innovative, versatile sensors and guidance systems. Raytheon’s unmanned system sensors account for 17.6% of its revenue mix and 20.1% of its operating mix.

Raytheon’s leadership position in these futuristic technologies has enabled the company to rack up a dramatic return on equity (ROE) of 19.0%, compared to an industry average of 7.7%. The best news is that, despite these impressive long-term trends in its favor, the company still appears to be undervalued. With a price-to-earnings (P/E) ratio of 11.7, this company is a bargain, especially compared with the defense industry’s P/E of 39.4. Overall, the company trades at a discount to both its peer group and the S&P 500.

Raytheon also represents a high dividend stock that’s coupled with a clean balance sheet. In late March, the company boosted its annual dividend payout rate by +21%, from $1.24 to $1.50 per share, for a dividend yield of 2.6%. With comparatively little debt and a strong earnings outlook for this year and next, Raytheon’s healthy dividend should be sustainable.