Defense deals give big boost to bottom line

If you thought that defense contracts were the eminent domain of traditional arms dealers, you’re sadly mistaken. The lion’s share of Army, Navy, Air Force and Marine Corps contracts go to the usual suspects such as Boeing, Lockheed Martin and General Dynamics (a “Motley Fool Inside Value” pick), but the pie is so big, and information technologies are becoming such an integral part of the military, that even Silicon Valley geeks can grab a serious slice.

Hewlett-Packard (NYSE: HPQ), for example, recently renewed an information technology (IT) support contract with the U.S. Navy, adding another three years of services for as much as $3 billion in cash. This is serious money even for a giant like HP, because the Navy network is among the largest IT installations anywhere.

It doesn’t stop there. IBM also has a strong relationship with the military and federal government and has a massive contract for automating forms across the Army, among other things. In fact, pick any large IT enterprise, and chances are that it dips into government spending on a regular basis.

The defense sector is full of surprises. Don’t miss out on a chance to get some value out of Uncle Sam’s spending habits – pay attention to where government dollars are going.

Ask the Fool

Q: Why would a stock begin trading in the morning at a very different price than the one it closed at the day before? – H.W., Memphis

A: Some news or rumors may have come out since the stock closed. Perhaps the company is buying another company or is being bought out, or maybe surprisingly good or bad earnings were reported. Such developments can cause buy or sell orders to pile up all night long, resulting in big overnight price moves. Stock prices simply reflect supply and demand. If many investors are selling, the price drops – and vice versa.

Q: Is it true that dividends are taxed twice? – R.R., Duluth, Minn.

A: Indeed. Imagine that Wanton Punctuation Co. (ticker: ?#$@!) rakes in $100 million in sales, and after subtracting expenses, keeps $20 million as its operating profit. It will then be taxed on that. Corporate income tax rates can approach 40 percent, though many companies are able to shield much of their income.

Wanton can do many things with what remains. It can buy back and retire some of its own shares (increasing the value of remaining shares), build more factories, hire more workers, and so on. If it pays out some of these earnings as dividends to shareholders, though, the shareholders will be taxed on it as income. Presto – that money has now been taxed twice.

This is why investors might prefer to see a company using its money to build more value for shareholders without paying out dividends. It’s also why some companies are opting to repurchase shares, which rewards shareholders in a tax-free way. (Repurchasing shares is wasteful, though, when a stock is overpriced.)

My dumbest investment was Seattle Film Works. I evaluated the stock in 1997 and estimated that at $9 per share, it was about 40 percent undervalued relative to its intrinsic value. I kept buying as it plunged. Renamed PhotoWorks, it was ultimately bought by American Greetings for less than a dollar per share. It taught me to take management statements with a grain of salt and to look for catalysts before jumping in. Thankfully, I was diversified and have done well with other picks. – Glen, Oklahoma City

The Fool responds: It’s indeed helpful to identify catalysts before investing – events or developments that you expect will propel a stock toward its fair, intrinsic value. Examples of catalysts include the launch of an exciting new product, the economy emerging from a recession and lifting cyclical stocks, a company launching operations in a new country, and the spin-off of part of a company. It’s also smart to try to determine (as much as you can) a stock’s intrinsic value, so that you can get a handle on how undervalued it may be. Learn more at www.fool.com/how-to-invest.