Defense contractors

[Spekulatius]

Earnings have been pretty good for defense contractors. LMT, NOC and LHX all best their earning targets.

 

I was just looking at LHX’s numbers which reported earnings gs today.

 

Looking back, Harris was a ~$6B company with close to 20% operating margins. L3 was a bit more than $10B revenue company, but their operating margins were much lower - 11%.

 

Now, if we revenue weigh this we expect to see ($6*0.2+$10.2*0.11)/($6+$10.2)=14.3% margin. LHX in the last quarter achieved a 17.9% operating margin already.

 

The quarter before were 18.2%, 17.5% and 17.3% respectively. Seems like things are generally moving in the right direction.

 

Defense is an area where economies of scale are very real. As a small contractor , working in defense can be a fairly trough business, because awards can be lumpy and the bigger guys can be squeezing you on margins.But once you are a prime contractor and have your lobbyist working for you Etc. so you understand which way the wind is blowing in thr Pentagon and economies of scale, then things get much much better.

[Spekulatius]

I own a bit of LMT, but I've also always really liked Elbit Systems. A bit smaller and more specialized, but very well managed company.

 

I looked at ELBIT Systems (ESLT) as it trades near its low ($113 vs $110 - 52 week low). I still don’t see it trading at a discount to US defense plays that I think are lower risk.

 

It is a nice outfit that I owned before - I bought it around $30 in 2012 and sold it for more than a double in 2013 (looking back at my records) but it was very cheap back then and trading lower than US defense plays.

[Foreign Tuffett]

I own a bit of LMT, but I've also always really liked Elbit Systems. A bit smaller and more specialized, but very well managed company.

 

I looked at ELBIT Systems (ESLT) as it trades near its low ($113 vs $110 - 52 week low). I will don’t see it trading at a discount to US defense plays that I think are lower risk.

 

It is a nice outfit they I owned before - I bought it around $30 in 2012 and sold it for more than a double in 2013 (looking back at my records) but it was very cheap back then and trading lower than US defense plays.

 

Maybe people are worried about fallout from ELBIT selling 'suicide drones' to Azerbaijan given the conflict w/ Armenia?

 

https://www.jpost.com/israel-news/israels-elbit-systems-sells-azerbaijan-skystriker-suicide-drone-577053

 

Just a guess off the top of my head.

[Spekulatius]

I own a bit of LMT, but I've also always really liked Elbit Systems. A bit smaller and more specialized, but very well managed company.

 

I looked at ELBIT Systems (ESLT) as it trades near its low ($113 vs $110 - 52 week low). I will don’t see it trading at a discount to US defense plays that I think are lower risk.

 

It is a nice outfit they I owned before - I bought it around $30 in 2012 and sold it for more than a double in 2013 (looking back at my records) but it was very cheap back then and trading lower than US defense plays.

 

Maybe people are worried about fallout from ELBIT selling 'suicide drones' to Azerbaijan given the conflict w/ Armenia?

 

https://www.jpost.com/israel-news/israels-elbit-systems-sells-azerbaijan-skystriker-suicide-drone-577053

 

Just a guess off the top of my head.

 

Oh boy, these things are for pretending, not for actual use. The part with the live demonstration on an adversary driving a Jeep sounded bad too.

These things are basically a mini version of the V1 invented in WW2 by the Nazi’s - carbon neutral due to their electrical engines.

 

Unrelated to this, my holding Rheinmetall (RHM.DE) had pretty strong results in their defense sector. it’s an industrial conglomerate that used to be 1/2 defense and the rest automobile supplier, but not the mix is netter than 60/40 due to defense growing and the automobile part shrinking.

With European defense spending surging, RHM has one of the best growth profiles in the defense sector, imo. I recently rebought some shares around 63€which I had sold around 80€- paying attention to the sometimes widely fluctuating shares can pay off.

https://www.rheinmetall.com/en/rheinmetall_ag/press/news/latest_news/index_21696.php

[Spekulatius]

Putting this here for a lack of a better location. Interesting Sunday read on the Canadian Avro fighter project which got canceled in 1959:

https://www.bbc.com/future/article/20200615-the-record-breaking-jet-which-still-haunts-a-country

 

For those interested, the BBC has great long form articles about aviation history right now and the above is one of them.

[Spekulatius]

NOC sells their service business for $3.4B:

https://investor.northropgrumman.com/news-releases/news-release-details/northrop-grumman-sell-federal-it-and-mission-support-business

 

This continues the portfolio restructuring that has been ongoing with NOC. They spent  $7.8B for Orbital Science in 2018 and this worked out very well. I think it makes sense for NOC to sell the weaker IT service business. They can do this non dilutive for earnings buy using the proceeds to buy back shares and reducing debt (which increased with the Orbital Science acquisition).

[Dalal.Holdings]

I'm not very knowledgeable about Northrop's segments--is "federal IT and mission support business" in the same sphere as Palantir's business?

 

I'm guessing as far as any overlap with Palantir, it's less IT and more of the mission support stuff...

[Dalal.Holdings]

I'll answer my own question:

 

2016:

https://www.politico.com/story/2016/08/palantir-defense-contracts-lobbyists-226969

 

In its latest fight, Palantir representatives claim the Army is purposely shutting out innovation, despite evidence that the company’ s solution for a new battlefield intelligence network is more effective than the initial version that was developed by Raytheon, Northrop Grumman and other contractors.

 

2019:

https://www.washingtonpost.com/world/national-security/palantir-wins-competition-to-build-army-intelligence-system/2019/03/26/c6d62bf0-3927-11e9-aaae-69364b2ed137_story.html

 

The Army has chosen Palantir Technologies to deploy a complex battlefield intelligence system for soldiers, according to Army documents, a significant boost for a company that has attracted a devoted following in national security circles but had struggled to win a major defense contract.

 

Industry experts said it marked the first time that the government had tapped a Silicon Valley software company, as opposed to a traditional military contractor, to lead a defense program of record, which has a dedicated line of funding from Congress. The contract is potentially worth more than $800 million.

 

https://www.defensenews.com/land/2019/03/29/palantir-who-successfully-sued-the-army-just-won-a-major-army-contract/

 

WASHINGTON — Silicon Valley-based Palantir, who sued the U.S. Army several years ago over the service’s procurement strategy of an intelligence analysis system, has won an Army contract to provide just that.

 

Palantir beat out Raytheon in a head-to-head competition to provide the Army a new tactical version of its Distributed Common Ground System—Army, or DGCS-A, The Washington Post first reported.

 

The contract to provide a new system — a “capability drop 1” version — is worth $876 million over 10 years. But the first delivery order is just for $20 million, according to an industry source.

 

Some similarities in my view with SpaceX vs incumbent defense contractors and Palantir vs the same group.

 

The incumbents have the benefit of cozy, long established relationships with their customers. The new entrants have the advantage of a superior product in select cases.

 

Probably best for some of the incumbent defense contractors to exit Palantir's space and stay where their advantages are (for now): military hardware.

 

[Spekulatius]

NIC service business was similar to $LDOS. It can be regarded as an outfit to rent out bodies (or perhaps workers with security clearance). The tech (if there is any)  isn’t owned but the company itself, but by the agencies.

 

This is different than Palantir. They run a much higher gross margin business where Palantir owns the tech.

[Foreign Tuffett]

NOC sells their service business for $3.4B:

https://investor.northropgrumman.com/news-releases/news-release-details/northrop-grumman-sell-federal-it-and-mission-support-business

 

This continues the portfolio restructuring that has been ongoing with NOC. They spent  $7.8B for Orbital Science in 2018 and this worked out very well. I think it makes sense for NOC to sell the weaker IT service business. They can do this non dilutive for earnings buy using the proceeds to buy back shares and reducing debt (which increased with the Orbital Science acquisition).

 

Yeah, this was the lowest quality and least differentiated part of NOC's business. The rest of the business is all (or nearly all) high tech stuff (space, autonomous and manned aircraft, ballistic missiles, cyber, sensors, etc). I completely agree that NOC making the right move here.

[fareastwarriors]

Lockheed Martin inks $4.4 billion deal to acquire Aerojet Rocketdyne

 

https://www.reuters.com/article/us-aerojet-m-a-lockheed/lockheed-martin-inks-4-4-billion-deal-to-acquire-aerojet-rocketdyne-idUSKBN28U0Z7

[Dalal.Holdings]

Thanks to this and "what is reasonably priced" thread.

 

I went in on LHX due to relatively capex light business, relatively fatter margins, and IMO more versatile business. I agree with Spek that margins post merger may yield further upside in addition to organic growth.

[KJP]

Interesting disclosure about the effect of the TCJA's mandatory five-year amortization period of R&D for tax purposes on slide 10 of Lockheed's earnings presentation today:  https://investors.lockheedmartin.com/static-files/64e5aa03-9023-423a-8908-2aae8c7015ac

 

My understanding is that for tax purposes starting in 2022, companies must capitalize and then amortize R&D over five years, rather than taking a full deduction for all R&D in the year the R&D expense is incurred.  Here's one explanation of this tax law change:  https://taxfoundation.org/research-development-expensing-tcja/

 

For example, if you're spending $10 billion per year in R&D, you've historically been able to get an annual $10 billion deduction.  But starting in 2022, your initial annual deduction would only be $2 billion (1 year of a 5-year amortization of $10 billion), resulting in an additional $8 billion of taxable profits in that year relative to prior tax years.  I believe this is the source of the additional $2.1 billion and $1.8 billion in 2022 and 2023 taxes referred to in the footnote to slide 10 of the Lockheed presentation.

 

That tax deduction will normalize over five years, though likely always create a bit of a drag relative to 100% immediate expensing due to inflation.  As the LMT slide shows, it also could cause some significant near-term declines in FCF.

[Dalal.Holdings]

L3Harris Technologies Announces 20 Percent Quarterly Dividend Rate Increase and New $6 Billion Share Repurchase Authorization

 

https://www.businesswire.com/news/home/20210128006099/en/L3Harris-Technologies-Announces-20-Percent-Quarterly-Dividend-Rate-Increase-and-New-6-Billion-Share-Repurchase-Authorization

[Spekulatius]

L3Harris Technologies Announces 20 Percent Quarterly Dividend Rate Increase and New $6 Billion Share Repurchase Authorization

 

https://www.businesswire.com/news/home/20210128006099/en/L3Harris-Technologies-Announces-20-Percent-Quarterly-Dividend-Rate-Increase-and-New-6-Billion-Share-Repurchase-Authorization

L3Harris thesis in one sentence:

20% EBITDA business (Harris) + 13% EBITDA (L3) margin business = 20% EBITDA margin business (L3Harris)

 

NOC had very strong revenue growth in the last quarter. LMT also looked good, but outlook disappointed a bit. All those will be buying back a lot of stock if they stay cheap.

[KJP]

Here's a short, high-level overview of the last 60 years of defense company performance:  https://fortunefinancialadvisors.com/blog/exploring-the-surprising-resilience-of-the-defense-industry/

 

It doesn't seem like an industry that ought to trade at below market multiples.

 

 

[DooDiligence]

https://abcnews.go.com/International/wireStory/us-gun-maker-colt-bought-czech-company-75847772

[Spekulatius]

Pretty good article in Barron’s about aerospace and defense:

https://www.barrons.com/articles/these-8-value-stocks-will-benefit-from-an-economic-recovery-51614337206

 

Touches upon BA, LMT, NOC, RTX

[KJP]

Pretty good article in Barron’s about aerospace and defense:

https://www.barrons.com/articles/these-8-value-stocks-will-benefit-from-an-economic-recovery-51614337206

 

Touches upon BA, LMT, NOC, RTX

 

Did you mean to link to the interview of Richard Aboulafia of Teal Group rather than the interview of John Rogers?  I couldn't find the Aboulafia interview online.

 

I enjoyed this Q&A from the Aboulafia interview: 

 

Answer:  "The International Air Transport Association says we get back to the 2019 traffic peak in early 2024. I say late 2022."

 

Question:  "That's fast."

 

Answer:  "The traveling public now has a half-century-record level of savings waiting to be thrown back at the vacations that they haven't been taking.  This is a recipe for the fastest recovery every."

 

Question:  "Which companies benefit the most from people flying again."

 

Answer:  "I could never pretend to be an investor, but I'm happy to offer five companies best positioned for the recovery comeback:  Raytheon, Northrup Grumman, Safran, Lockheed Martin, and Howmet Aerospace."

 

Question:  "What do you like about those five."

 

Answer:  "Lockheed Martin is the world's most important maker of combat-aircraft products, and that's a strong market.  They are also strong in missiles. . .  . Northrup Grumman: lots to like, strong emphasis on investing in the future of defense.  That focus won them the two legs of the nuclear triad, how the U.S. delivers nuclear weapons, that are being replaced -- ground-based ICBMs ad the strategic stealth bomber."

 

Those two investment theses have nothing to do with Aboulafia's purportedly variant view on the timeline of the comeback in commercial travel, nor anything to do with a "recovery comeback."  The questioner never acknowledges this or asks why Aboulafia's top "recovery" picks have nothing to do with his bold call on commercial aviation's comeback. 

 

More broadly, what percentage of commercial travel is business travel?  Will businesses adapations to COVID have a significant lasting effect on business travel?  A good and prepared reporter ought to be asking these types of follow up questions.

[ratiman]

Social security and Medicare or another fleet of bombers, what is it going to be?

 

 

 

[Spekulatius]

^KJP, yes I put in the wrong link - here is the correct one:

https://www.barrons.com/articles/how-boeings-problems-play-out-and-five-stocks-for-an-aerospace-recovery-51615589491

[Dalal.Holdings]

These are great businesses because even when they do a bad job, their main customer is a captive customer. And Congress just keeps writing the checks. Bad for taxpayers which is a shame. F-35 is a great example.

 

I think I prefer LHX to the big names because their products are involved in an array of different projects rather than having single contract risk. F-35, NASA Mars Perseverance Rover, Satellites, Drones, etc etc.

 

Because of this "diversification" of revenue streams, LHX also seems to have a lot lower risk of single big failures sinking its prospects (i.e. Boeing and 737).

 

Edit: and there's a lot less risk of LHX's sensor/antennae/avionic malfunctions becoming a huge potentially systemic headache for the co vs a large, complex project like an F-35 or 737 failing. A lot more simplicity to their biz.

[Spekulatius]

The F-35 is imo wrongly accused of being a failure but it is commissioned and works despite some deficiencies. It also can’t really fail because it is the only fighter platform there is and those platforms are almost like SAAS, they live for ~40 years (the F-35‘s projected life is until 2055). The F-15 is still around and still getting Development contracts for upgrades for situation where stealth doesn’t matter as much. It was developed in the 1970‘s.

 

LHX is a Great Outfit. They don’t own large programs, but they are involved in every one of them. I love their Proxy Statement 40% EBIT, 40% FCF and 20% Revenue growth. Plain and simple and shareholder friendly.

[no_free_lunch]

I agree in principle that the entire defense industry is cheaply priced relative to the market. Some of these companies give me deja vu to investing back in 2012. Earning multiples below 15 are common, share buybacks, dividends, it seems almost guaranteed money. I am long GD but I think there are even cheaper and better equities in defense. 

 

You can buy a basket to mitigate company risk but beyond how do you assess risk?  The only risks I see is that defense budgets get cut. It seems very unlikely to me but who knows.  Perhaps some epic accord is signed with China and Russia to demilitarized.  It seems things are going the opposite direction if anything. 

 

I am sold on the thesis, now looking for contrary opinions. In particular from the dem side of the board since they now control the checkbook.

[Dalal.Holdings]

The F-35 is imo wrongly accused of being a failure but it is commissioned and works despite some deficiencies. It also can’t really fail because it is the only fighter platform there is and those platforms are almost like SAAS, they live for ~40 years (the F-35‘s projected life is until 2055). The F-15 is still around and still getting Development contracts for upgrades for situation where stealth doesn’t matter as much. It was developed in the 1970‘s.

 

LHX is a Great Outfit. They don’t own large programs, but they are involved in every one of them. I love their Proxy Statement 40% EBIT, 40% FCF and 20% Revenue growth. Plain and simple and shareholder friendly.

 

I think of a project that is extremely delayed, vastly over budget (>$1 Trillion) as a failure. The fact that the USAF is relying on old fighters like the F-15 and F-16 is due to the failures of these contractors in developing a cheap, viable next gen fighter on time. The DoD is partly to blame for some of these problems, but I put more blame on the contractors.

 

The risk is black swan type: eventually America's adversaries develop better fighters because their defense firms are vastly more nimble and competent.

 

Or there is another black swan type risk like what SpaceX did to Boeing and LMT's space program (ULA): a much nimbler challenger emerges to disrupt them. My view is ULA will eventually be folded thanks to SpaceX. But lots of barriers to entry in defense and an Elon Musk type doesn't come around often...