The defense industry is in the middle of a swirl of headlines regarding impending budget cuts in the United States.  This threat is an overhanging risk for any of the major U.S. defense firms that rely on government contracts, primarily Lockheed Martin Corporation (NYSE:LMT), Raytheon Company (NYSE:RTN), and Northrop Grumman Corporation (NYSE:NOC).  The question to investors now is, should shares in these firms be dumped?

Sequestration, the $1.2 trillion in defense and non-defense discretionary budget cuts scheduled to go into effect this year, has many investors worried.  Indeed, Lockheed Martin derived 82% of its revenues from U.S. government contracts in 2011, including 61% directly from the Department of Defense budget.  The full impact of sequestration is unknown.  Lockheed acknowledged in its 2011 annual report that further significant cuts to military spending could cause material harm to its business.  In particular, investors in Lockheed Martin should pay close attention to the status of the company’s F-35 program.  The F-35 is Lockheed’s largest program, as it accounts for 13% of its sales.  Furthermore, the F-35 program is expected to represent an even higher percentage of the company’s sales in the future.

It appears that at least some of the expected cuts are priced into the shares of these defense companies.  Lockheed, Raytheon, and Northrop Grumman trade at trailing price-to-earnings ratios of 10.7, 10.1, and 8.7, respectively.  Furthermore, the dividend yields on these companies beat the yield on the broader market.  In an environment of historically low interest rates, the dividend yield on these three firms is attractive to many income-seeking investors.  Raytheon and Northrop Grumman both yield in excess of 3.3%, while Lockheed Martin has an even higher yield of almost 5%.

A positive note for Lockheed Martin is that it will not suffer from the drawdown of operations in Iraq and Afghanistan.  Funding of the two wars was confined under the Overseas Contingency Operations budget, which is separate from the Department of Defense budget.  The Department of Defense budget is where Lockheed Martin derives 61% of its U.S. government contracts, and that budget is only going to contract by about 1% in fiscal 2013 versus the prior year.  The Overseas Contingency Operations budget is where harsher cuts will be enacted.  Because of the gradual end to the wars in Iraq and Afghanistan, that budget will see cuts of almost 24% in fiscal 2013.