Defense contractors

[KJP]

Defense contractors have fallen alongside everything else.  On the theory that (ii) their primary customer (U.S. government) will keep paying, and (ii) neither Trump nor Biden (nor Cuomo 2020) will push for defense spending cuts in the near future, I've started looking at them.  I have no background knowledge, so these are some initial, first-pass, relatively uneducated thoughts.  I welcome comments and insights about the industry generally, specific companies listed below, or other companies I should add to the research list.

 

General industry thoughts:  Overall, it looks like strong, stable cash flows and some of the most dominant competitive positions you will find, e.g., BWXT in naval nuclear reactors and Huntington Ingalls in aircraft carriers.  The other IT/systems companies may have as big or bigger moats, but that's not as easy for me to assess one way or the other.  Many companies have significant pension liabilities, but the U.S. government is on the hook for most of it.  So, the balance sheet entry probably isn't a big concern.  There do, however, appear to be some differences in how the companies account for these pensions (FAS/CAS adjustments) in their discussions of operating income.  I need to look at that further.

 

BWX Technologies (BWXT) – Dominant in nuclear reactors for US Navy ships -- may have no real competition here; also has ancillary nuclear businesses (commercial reactors; radioisotopes; remediation; space/NASA) ; even with recent share price decline, it’s trading at 16x EV/EBIT

 

General Dynamics (GD) – Gulfstream is ~$1.5 billion EBIT non-defense segment – doubt there are long-term injuries due to Covid, unless we have deep recession/depression; rest of the business looks like very strong defense, such as Electric Boat – dominant general contractor for construction of US Navy submarines (Virginia and Columbia class); trading around 10x EBIT; recent cash flow from ops has lagged due to slow payment on 1 international contract on which it received $500 million in January 2020 (see note H to Item 8 in 2019 Annual Report); capital allocation weighted towards dividends; levered at ~2.5x EBIT; large bump in backlog due to Virginia class subs, Block V

 

Raytheon (RTN) – Large information systems, sensors, cybersecurity and missile businesses (both offense and defense); 30% international; very strong recent bookings growth; merger with United Technologies targeted to close in 2020 (haven’t looked at implications of this); very little net debt ($4.3 billion cash; $4.7 billion debt); appears to trade at 8.5x EBIT but significant CAS pension adjustment in operating earnings; better cash flow than GD, due in part to GD’s receivable issue

 

Huntington Ingalls Industries (HII):  Largest US Navy shipbuilder, maintainer, modernizer – aircraft carriers (sole source), amphibious assault ships, destroyers, subs (likely second to GD; duopoly that splits contracts); big recent backlog growth from USN orders (e.g., 2 aircraft carriers; looking to grow IT, unmanned systems, and remediation services; “Technical Solutions” segment has low single-digit margins – why?; exiting high point in CapEx cycle (shipyard expansion) – should see big ramp in FCF as a result; trading at ~13.5 EBIT (without accounting for CAS adjustment); levered ~2x EBIT

 

Nothrup Grumman (NOC):  Haven't looked at it yet

 

Lockheed Martin (LMT):  Haven't looked at it yet

 

[Xaston]

I welcome comments and insights about the industry generally, specific companies listed below, or other companies I should add to the research list.

 

 

I would just say that the ethical considerations for buying such stock are inherently large, so do a bit of soul searching before you buy, because it would be a lot better emotionally than buying now and later realizing you don’t find it ok.

 

Same thing should be done for all investments, just the scale of the pros and cons are larger here so it’s probably worth more contemplation than an average investment.

 

[KJP]

Regarding the FAS/CAS adjustments I mentioned in the first post, after reading a few of the 10-Ks for these companies, I believe it works like this: 

 

Pension costs associated with US government contracts represent reimbursible costs ultimately paid for by the government.  The timing of those payments are governed by the government's accounting standards, known as "CAS".  These companies rely on CAS when they report their segment operating figures.  So, the segmental net sales, COGS, and operating profit reflect real-world CAS reimbursements.

 

The company's consolidated audited financials, however, must be reported according to GAAP, which has different cost recognition principles.  Thus, GAAP pension expense and CAS pension expense on the income statement can vary widely, but should converge over time.  The CAS/FAS adjustment to "other income" reconciles the GAAP annual pension expense to the CAS pension expense embedded in the reported COGS.  Thus, in years where the CAS figure is higher than the FAS figure (as in recent years), the reconciling entry will be positive and increase reported earnings, and vice versa in years that FAS is lower than CAS. 

 

I believe the CAS numbers, i.e., the pre-CAS/FAS adjustment, a better reflect the underlying business economics.  I'm particularly interested in whether others agree or disagree and why.

 

Actual cash contributions to the pension plans are governed by a different set of ERISA rules, as modified by the Pension Protection Act of 2006.  So, that requires its own analysis, separate from what is recorded on the annual income statement. 

 

There's a discussion of the pension issue in this VIC write up and its comment thread:  https://www.valueinvestorsclub.com/idea/LOCKHEED_MARTIN_CORP/7341821351

Note that back at the time of that writeup, Lockheed's most recent CAS/FAS adjustment was negative, rather than positive, as reflected in the writeups chart.

 

Also of note is the multiples at which these companies once sold for.  There are several VIC writeups of these companies from 2011/12 showing much lower multiples than are available today, even after the recent declines, apparently out of fear of upcoming defense budget cuts.  In addition to the Lockheed writeup above, see:

 

https://www.valueinvestorsclub.com/idea/HUNTINGTON_INGALLS_IND_INC/1604269707

https://www.valueinvestorsclub.com/idea/GENERAL_DYNAMICS_CORP/8583285979

 

 

 

 

[scorpioncapital]

What's so unethical about the defense of nations? Even libertarians believe basic function of a nation is defense. However one might argue they shouldn't be public stocks. That is an argument i could go with. The military industrial complex is not going away, ever , and I don't think is so politically charged as tobacco companies since the state itself is never going to stop spending on this . Even peaceful countries have a military sector. It's just something you do.

 

[meiroy]

I bought some VEC and VSEC on recent lows.

 

[Spekulatius]

I like GD and bought some, averaging down. Sold it after the bounce on Thursday. Good business and Uncle Sam will pay the bills. I also think the corporate Jet business may actually benefit longer term because the upper crust will avoid flying with airlines for fear of infections and because so many flights will remain cancelled. short term there will be cancellations, but they have a huge backlog.

 

I don’t think Uncle Sam will cancels nuclear submarines and these types of things. If anything, the epidemics will increase international tensions. I also like BAESY, same idea. I Buy them back on retrenchments.

[Cigarbutt]

Disclosure: Department of defense contractors are on a long term watchlist and would make them easily 10% of invested funds if the price is right. i may contribute to this discussion more fully in due course.

 

IMO, the pension issue is very significant. I guess it has the potential to be smoothed away over time but the potential long term cash flow implications are significant.

If interested:

https://www.gao.gov/assets/660/651387.pdf

https://us.milliman.com/insight/Pension-Funding-Index-March-2020

[thowed]

I think ethical considerations should be on a case by case basis.

 

I agree that we all want to defend our nations.  And amazing things (e.g. the internet?) have come from military technology.

 

But I would never touch a defence firm that made landmines.

 

[Spekulatius]

Disclosure: Department of defense contractors are on a long term watchlist and would make them easily 10% of invested funds if the price is right. i may contribute to this discussion more fully in due course.

 

IMO, the pension issue is very significant. I guess it has the potential to be smoothed away over time but the potential long term cash flow implications are significant.

If interested:

https://www.gao.gov/assets/660/651387.pdf

https://us.milliman.com/insight/Pension-Funding-Index-March-2020

 

For defense companies, the pensions are paid by the tax payers. The costs are rolled into the contracts.

[Cigarbutt]

Disclosure: Department of defense contractors are on a long term watchlist and would make them easily 10% of invested funds if the price is right. i may contribute to this discussion more fully in due course.

IMO, the pension issue is very significant. I guess it has the potential to be smoothed away over time but the potential long term cash flow implications are significant.

If interested:

https://www.gao.gov/assets/660/651387.pdf

https://us.milliman.com/insight/Pension-Funding-Index-March-2020

For defense companies, the pensions are paid by the tax payers. The costs are rolled into the contracts.

Your sentence is correct, assuming the absence of a redefinition of what is an american unsecured creditor.

Until very recently, it was felt that Boeing would never need a bailout because of its defense contracts. Things can change fast and pendulums do swing.

I still think that investing in those makes sense (oligopoly etc) but investing in the sector may require reading the following:

https://www.amazon.com/Prophets-War-Lockheed-Military-Industrial-Complex-ebook/dp/B0047T86BA

Republicans typically hate the book, while Democrats love it.

Sorry to bring politics but IMO it doesn't matter if you love or hate the book. What matters is who is (or will be) in power.

The pension numbers are so large and, because of the long term nature of the numbers, moderate changes (especially if correlated) in assumptions could result in massive implications.

[KJP]

Disclosure: Department of defense contractors are on a long term watchlist and would make them easily 10% of invested funds if the price is right. i may contribute to this discussion more fully in due course.

 

IMO, the pension issue is very significant. I guess it has the potential to be smoothed away over time but the potential long term cash flow implications are significant.

If interested:

https://www.gao.gov/assets/660/651387.pdf

https://us.milliman.com/insight/Pension-Funding-Index-March-2020

 

I agree on both points.  Given the size of the pensions here, and how they impact reported financials, I'm doing more reading to understand how they work.  As for price, I believe current prices still reflect a bullish take on future military spending, in contrast to the multiples you had in 2011/12.

[sleepydragon]

Seems these defense companies employ way too many people...

Maybe they have problems to lay-off people as govt contractor.

HII for example is 8bn mktcap but employ 40k. That’s only 200k revenue per employee.

Google, Visa etc is at least 10 times that

Even banks are higher.

 

[scorpioncapital]

depends which one.. LMT for example is about 550k per employee. But you cannot compare a capital intensive business with an asset lite cloud stock like Google. Boeing also has very large pension liabilities. They are on the balance sheet. I think the return expectations on the pensions are like 7-8% depending which company you look at. You can judge if this is crazy or not. Also many have gone to no more pensions but a kind of self directed retirement plan with some matching funds. Otherwise they'd go bankrupt like the US car manufacturers.

 

[KJP]

Seems these defense companies employ way too many people...

Maybe they have problems to lay-off people as govt contractor.

HII for example is 8bn mktcap but employ 40k. That’s only 200k revenue per employee.

Google, Visa etc is at least 10 times that

Even banks are higher.

 

Why would you expect the revenue per employee at company that builds submarines and aircraft carriers (Huntington Ingalls) to resemble the revenue per employee at companies like Visa or Google? 

 

Put another way, the output of an a hour's worth of very highly-skilled software coding (i.e., code may be used and resold an infinite number of times -- labor output is highly scalable.  On other other hand, the output of an hour's worth of a very highly-skilled welding creates a physical product that can only be sold once.  The labor output is not scalable in the same way.  So why would you expect the labor components of the two business models to be in any way comparable?

[Jurgis]

They should have robots building submarines, aircraft carriers and fighter jets with automatic weapon systems.

 

 

 

 

 

What could go wrong.

[scorpioncapital]

What one should compare is the intangible moat quality of Google vs mandatory defense spending. Even Libertarians would agree national defense is a primary function of the state. But which is the stronger moat? Google may have anti-trust issues. Government military spending may be cut.

[Spekulatius]

What one should compare is the intangible moat quality of Google vs mandatory defense spending. Even Libertarians would agree national defense is a primary function of the state. But which is the stronger moat? Google may have anti-trust issues. Government military spending may be cut.

 

Defense spending as a % of GDP has slowly been going down over time, however it also has become more high tech. So less boots on the ground (salaries to pay) and more expensive toys. The last few years have been great for defense Companies. I expect that Russia and China which both are modernizing their military are keeping us on our toes. You can’t really keep a reserve currency without projecting power, imo. It’s a necessity for us to remain the strongest and most capable military power.

[sleepydragon]

https://ctmirror.org/2020/06/22/navy-electric-boat-reach-10-3-billion-deal-to-begin-building-columbia-class-subs/

 

[K2SO]

What's so unethical about the defense of nations?

 

Nothing unethical about "defense."

Athough it's a bit of Orwellian wordplay since these tools are just as often used for "offense."

And people die because of them.

 

Personally I have no ethical issue owning the stocks, but other people do, and I respect that.

 

[Spekulatius]

I recently (and today) added to NOC. They are sort of the sole bidder on two huge contracts coming up - the B-21 stealth bomber and the GBDS (intercontinental nuclear missiles). The US ground based nuclear missiles are dated and probably need to be replaced (unless the US is shelving this which is unlikely) since it pre Cold War and was out in place in the 1970’s. Twos programs are $60-70B in Size which is substantial for ~$36B company like NOC.

 

Other stocks in my watchlist are $LHX (strong in sensors and electronics ), Shipbuilder HII (cheap, but somewhat of a low tech metal fabricator ) and $LMT.

[Xerxes]

I recently (and today) added to NOC. They are sort of the sole bidder on two huge contracts coming up - the B-21 stealth bomber and the GBDS (intercontinental nuclear missiles). The US ground based nuclear missiles are dated and probably need to be replaced (unless the US is shelving this which is unlikely) since it pre Cold War and was out in place in the 1970’s. Twos programs are $60-70B in Size which is substantial for ~$36B company like NOC.

 

Other stocks in my watchlist are $LHX (strong in sensors and electronics ), Shipbuilder HII (cheap, but somewhat of a low tech metal fabricator ) and $LMT.

 

Spekulatius, Great pick !

Northrop is the best of the bunch, however beware that for GBDS there is reason why Boeing dropped out and the reason was not it being preoccupied with the MAX' woes. I believe the model that Pentagon is going with for GBDS is one that it will own the underlying technical baseline of the GBDS program as oppose to the contractor owning it. Meaning that the best part of the contract which is the 50+ year aftermarket can be re-distributed by the Pentagon to other parties (which may or may not include Northrop).

 

On the other hand, Boeing went hard for the TX fighter trainer, (and got it) because it knew that it could sell what is develops through taxpayer money through international markets. i.e. (the F-16 model with Lockheed). For GBDS, Northrop has no international market for these Doomsday weapons and if it cannot own the technical baseline (thus not owning the Aftermarket), it remains to be seen how profitable that "captive" program will be even if it is the sole bidder. The +$50 billion value for GBDS its huge, but most of it is not front-loaded.

 

But i very much like Northrop, anyways. I think a combination of Northrop, Lockheed, General Dynamics and Raytheon Technologies gets one covered on the nuclear triad and then some. The last two are perhaps cheaper due to their exposure to business and commercial aviations.

[Spekulatius]

I recently (and today) added to NOC. They are sort of the sole bidder on two huge contracts coming up - the B-21 stealth bomber and the GBDS (intercontinental nuclear missiles). The US ground based nuclear missiles are dated and probably need to be replaced (unless the US is shelving this which is unlikely) since it pre Cold War and was out in place in the 1970’s. Twos programs are $60-70B in Size which is substantial for ~$36B company like NOC.

 

Other stocks in my watchlist are $LHX (strong in sensors and electronics ), Shipbuilder HII (cheap, but somewhat of a low tech metal fabricator ) and $LMT.

 

Spekulatius, Great pick !

Northrop is the best of the bunch, however beware that for GBDS there is reason why Boeing dropped out and the reason was not it being preoccupied with the MAX' woes. I believe the model that Pentagon is going with for GBDS is one that it will own the underlying technical baseline of the GBDS program as oppose to the contractor owning it. Meaning that the best part of the contract which is the 50+ year aftermarket can be re-distributed by the Pentagon to other parties (which may or may not include Northrop).

 

On the other hand, Boeing went hard for the TX fighter trainer, (and got it) because it knew that it could sell what is develops through taxpayer money through international markets. i.e. (the F-16 model with Lockheed). For GBDS, Northrop has no international market for these Doomsday weapons and if it cannot own the technical baseline (thus not owning the Aftermarket), it remains to be seen how profitable that "captive" program will be even if it is the sole bidder. The +$50 billion value for GBDS its huge, but most of it is not front-loaded.

 

But i very much like Northrop, anyways. I think a combination of Northrop, Lockheed, General Dynamics and Raytheon Technologies gets one covered on the nuclear triad and then some. The last two are perhaps cheaper due to their exposure to business and commercial aviations.

 

Xerxes, thanks for the commentary on the GBDS program, I wasn’t aware of this. Nevertheless, I think NOC is doing a good move here, as they stated in a CC that they want to get into the missile business and don’t mind spending Capex to do so. That makes sense to me.

 

I remember when Grumman and Northrop merged and both were considered dogs then, but they have done quite well. Generally, I found that mergers in defense often work out well, which also leads me to LHX (merger product of Harris and L3). I kind of know them in Lynch sort of way since during my carrier , I often work to supply defense companies and those are well known to me. L3 itself was a rollup, but they did quite well concentrating on sensors and electronics and I think the merger with Harris is a winner too. So I bought some shares in today’s weak price action. LHX is not a prime contractor, but they supply critical components and subsystems and do so with great margins.

 

I know that Mr Market is concerned about a democratic victory here but quite frankly, I think the outlook for US defense contractor is quite OK here. Both Russia and China are reducing manpower of their marked forces, but vastly increase their offensive capabilities and I expect the US will have to counter this, no matter who is in charge.

 

i expect the military of the future to be vastly smaller (at least in terms of boots on the ground), but getting increasingly more technical and sophisticated and I think it will shift the defense budget from salaries to R$D and Capex, which is good for defense contractors.

 

About the worst thing they can happen for defense contractors is a low tech war against terrorist like we had from 2001 to 2014 that sucks up the budget from salaries , contractor work and bribes in hostile countries and negate the wear and tear in existing equipment (which is low margin work), instead of working on new toys.

 

[scorpioncapital]

That's why I think you should invest in defense cos with top technology and teams. And Space. I'm not sure if there is a rule saying they can't do commercial work. E.g. BA is mostly commercial but some government %. The military contractors are mostly government with some %, more or less, commercial. Also I am not sure exactly how they benefit from their work. Are they like Universities where they license , spin off or sell their technology? Or is it one time contracting gains? Maybe they spin-off their young entrepreneurial businesses? Although not sure if these companies can ever be said to be young and entrepreneurial.

[Xerxes]

Spekulatius,

Looks like we have the same background more or less.

Agreed that the gems in the A&D are the rollups that happen in the shadow of the giants with the headlines.

 

I recommend you add this Podcast to your roster, if not there already. There is wealth of info there. I have been reading Aviation Week for 10 years+.

I love the magazine and get the hardcopy at my door. Podcast => https://aviationweek.com/check6

 

Specifically, on Northrop Grumman and GBDS, here is the title. Great stuff to listen to while jogging.

https://aviationweek.com/defense-space/podcast-nuclear-modernization-point-no-return

 

On L3, itself it was a minor spinoff from Lockheed, with "L" from the Lockheed being one of the three "L"s in L3. The other two "L"s being individuals/management when L3 was created. If you are interested, one of the other "L" started his second investment vehicle, doing roll-ups in electronic/defense (i.e. C4ISR) etc.

 

Here is the related Podcast => https://aviationweek.com/air-transport/podcast-challenges-southwest-spacex-c4isr

 

 

 

[Xerxes]

On elections, i don't think it will be a factor, in the "pivot" back to great power competition.

U.S. national security is far less concerned with the Persian Gulf, now that U.S. is the top oil producer.

 

The long term trend will be that of dis-engagement from the Gulf region, and subcontracting Saudi and Israel to do their bidding.