Defense contractors

[Spekulatius]

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.

 

I own NOC, LHX, LMT and GD (in that order). I was initially overweight GD (actually bought some as low as $100 and change) but reduced in favor over the others.

 

The risk that is Common with all of them is cuts in defense spending. air is possibility, but with MMT now making the rounds and threats from China and to a lesser extend Russia increasing in their sophistication it seems like a bad idea right now.

 

If cuts in defense spending were going to happen, I expect another round of rationalization and consolidation and massive share buybacks just like what happened from 2010-2013. Consolidation will perhaps not amongst the prime contractors but all those secondary ones underneath. Those mostly are not pure play defense, they will just move resources to other areas. I work for what is one of the secondary ones (supplying the big ones with components so to speak) and I know for sure that if the business gets subscale, the effort is just going to be moved into commercial activities.

[Spekulatius]

Potus defense proposal is out - calls for 1.8% increase. Seems bullish considering the low expectations:

https://www.politico.com/news/2021/04/08/biden-pentagon-budget-480476

[scorpioncapital]

8 hours ago, Spekulatius said:

Potus defense proposal is out - calls for 1.8% increase. Seems bullish considering the low expectations:

https://www.politico.com/news/2021/04/08/biden-pentagon-budget-480476

If inflation is or is likely to be 2 to 3% as the Fed wants, wouldn´t 1.8% be below inflation growth rate, thus a decrease in real terms? True it´s only for 1 year but already we can say it is negative real growth rate. I guess you could hold defense stocks as bond equivalents but it isn´t very ambitious. One could expect perhaps a slight positive return, better than holding say government debt but that isn´t saying much. 

Edited April 11, 2021 by scorpioncapital

[Spekulatius]

5 hours ago, scorpioncapital said:

If inflation is or is likely to be 2 to 3% as the Fed wants, wouldn´t 1.8% be below inflation growth rate, thus a decrease in real terms? True it´s only for 1 year but already we can say it is negative real growth rate. I guess you could hold defense stocks as bond equivalents but it isn´t very ambitious. One could expect perhaps a slight positive return, better than holding say government debt but that isn´t saying much. 

The news is good, because the expectations were for a flat budged and 1.8% growth is better than flat.

The defense contractors don’t really need much growth to generate good returns for shareholders. When you look at historical data, the growth in the defense budget wasn’t all that great (less than GDP), yet through a combination of higher budget share, dividends and stock buybacks, double digit returns have been achieved for shareholders.

 

From current levels I can see returns of about 10% for LHX, LMT and NOC going forward, which I think will be far higher than what can be expected from the SPY.

[Spekulatius]

NOC results were quite strong, due to new programs contributing ( GBSD, space, classified) so this is just a friendly reminder (thanks to @lhamtil from Twitter) that NOC has beaten the QQQ over the last 10 years as well as 20 years (NOC has underperformed the QQQ since 2018 though).

 

Edited May 6, 2021 by Spekulatius

[Spekulatius]

$LHX, running a tight ship. Probably the best management team out there except maybe $NOC.

https://finance.yahoo.com/news/l3harris-reports-strong-second-quarter-103000248.html

 

It is not a cheap stock anymore, but they execute very well.

[fareastwarriors]

Anything of concern with the Lockheed CFO resigning immediately “due to personal reasons” ?

 

https://www.marketwatch.com/story/lockheed-martin-cfo-steps-down-271628027601

[Spekulatius]

5 hours ago, fareastwarriors said:

Anything of concern with the Lockheed CFO resigning immediately “due to personal reasons” ?

 

https://www.marketwatch.com/story/lockheed-martin-cfo-steps-down-271628027601

Probably this:

 

[Xerxes]

CEO video: Maximizing shareholder and stakeholder value at Raytheon | EY - Global 

[Xerxes]

Lockheed needs to re-assess its 5-year plan. I will post if there are any interesting podcast/articles from AW on this.

 

Stock down 10%

Edited October 26, 2021 by Xerxes

[rosemontseneca]

What impact do we think inflation has on the group?

 

Struggling with this question.  Assume it all gets passed through in the medium/long term, but how much turnkey risk do they have on longer-term fixed price work? 

[Spekulatius]

For those interested in defense service cos. $SAIC is currently a decent value proposition. They do some critical works on advanced projects, like project management and system integration. I bought some shares today at $82.XX (starter position).

There is some recent VIC writeup too. It’s a boring  slow growing business, but generates a lot of cash. FCF yield should be close to 10%, It’s a great business in a way, because there is virtually no Capex required. While the business itself is low growth, the FCF allows for accretive acquisitions or share buybacks from time to time. They did the last one a couple of years ago and have now worked down the leverage to about 3.5x and restarted buybacks very recently.

 

I like SAIC better than close peer LDOS, but that’s subjective somewhat.

Edited December 10, 2021 by Spekulatius

[Spekulatius]

$CACI popped up on my watchlist as it tanked today (slight earnings miss) so I bought a few shares. Looks like it's trading for a ~10% FCF yield. Need to do more work on this one, but I really want to fill up the defense part after selling off LMT and NOC in my IRA's (due to more stretched valuations)  . I also added a bit of $SAIC. I do feel that CACI may be a better bet.

 

Track record looks good, but one can also tell when the sequestering was going on from ~2013-2015. FWIW, there is a VIC short recommendation from this time. Stock has roughly tripled since then. Cash from ops (which is almost = FCF because it's a service business with little capex) also almost tripled.

https://www.valueinvestorsclub.com/idea/CACI_INTL_INC__-CL_A/6122444798

 

 

Edited January 31, 2022 by Spekulatius

[Spekulatius]

Dating myself here, but I regard CACI and SAIC basically as utility like income streams and value them based on levered FCF yield. Here is the LT chart for CACI:

 

Both CACI and SAIC do have a trashier credit rating (BB, BB+)than the primes LHX, LMT or NOC, so I keep Position smallish. If credit markets don’t do well, these names could be smacked around a bit too.

 

Edited January 28, 2022 by Spekulatius

[CafeB]

Really appreciate your comments on services companies, @Spekulatius

 

Would appreciate if you would be willing to elaborate briefly, by way of orientation:

 

--your comment on preference for SAIC over LDOS

 

--your comment on possible preference for CACI over SAIC

 

--any thoughts on BAH?

 

--any thoughts on switching costs? Although services not as capital-intensive as products, winning product platforms are produced and sustained for multiple generations in some cases--to the extreme that Congress buys what the Pentagon no longer wants. Assuming the industry as a whole benefits for many years to come as a member of the military-industrial complex, what factors limit competition among the companies, including on price? (I note comment in 2020 VIC write-up that "SAIC collaborates with competitors to bid on large contracts" sometimes.) How might a layman evaluate claims about proprietary technologies?

 

As an aside, recall casually following KEYW for a while from its 2010 IPO. I see now that it was acquired in 2019 by Jacobs, which appears to have significantly changed its portfolio of businesses to the extent that E&C industry classification is partial mischaracterization. I don't know if it might be of interest.

 

Thank you very much

Edited January 31, 2022 by CafeB
re: Jacobs

[Spekulatius]

@CafeB Lot‘s unpack from your post.

 

While I think contract favor the incumbent, we have seen large service contracts change hands so to speak. It’s not the norm, but it does happen, so I don’t switching costs are all that high.

 

Each of these companies has some specialized where they have competence. look at this this way, if you experts in satellite communication tech and now want to win a contract for a submarine drone ship, would the existing expertise of you employees be helpful? Probably not.

 

As for LDOS, I just have bad vibes about them due to corruption scandals ( read NY city contract overcharging ) and the political donations. I don’t see anything that would entice me to pick them over SAIC or CACI either, so I just decided to leave the stock alone.

 

On BAH - I traditionally avoided the stock, because it traded at a substantial premium to the epithets mentioned here. I can see why though- BAH ha better margins and shown better organic growth which warrants a higher multiple. So I recently bought some shares in BAH as well around $74. The stock has been hit by COVID-19 this winter, which crates the stock but should be temporary.

Edited February 12, 2022 by Spekulatius

[Spekulatius]

Did AJRD just sell off because Putin's attack on Ukraine is imminent? C'mon. Maybe my fundamental view of the company is flawed, but war sure won't hurt it. Bought a few more shares.

[LearningMachine]

22 minutes ago, Spekulatius said:

Did AJRD just sell off because Putin's attack on Ukraine is imminent? C'mon. Maybe my fundamental view of the company is flawed, but war sure won't hurt it. Bought a few more shares.

https://www.reuters.com/business/aerospace-defense/lockheed-martin-terminates-44-bln-deal-acquire-aerojet-rocketdyne-2022-02-13/

[Spekulatius]

7 minutes ago, LearningMachine said:

https://www.reuters.com/business/aerospace-defense/lockheed-martin-terminates-44-bln-deal-acquire-aerojet-rocketdyne-2022-02-13/

I realize this, but this was pretty much known before. The selloff seems to have occurred after another one of these Ukraine scares.

[CafeB]

On 2/12/2022 at 5:07 PM, Spekulatius said:

BAH ha better margins and shown better organic growth

 

BAH interesting

 

Thanks again

[Spekulatius]

For disclosure - sold my few shares in SAIC this AM about flat. The reason is that every one of the defense service contractors has taken a hit from Omnicom - BAH, CACI, LDOS. Maybe SAIC escapes the carnage but I think near term, the risk skews to the downside.

[Xerxes]

 

Here is a great podcast on aerospace & defense that I usually follow 

 

[grc1980]

24 minutes ago, Xerxes said:

 

Here is a great podcast on aerospace & defense that I usually follow 

 

 

Thank you, I've been looking for a good podcast in this area.  I'll have a listen to this over the next few weeks.

[Xerxes]

I would also recommend this. A lot of good content on commercial and aerospace market. You can skip the more technical episodes and focus on the business/market related episodes. 

 

I am subscribed to the print version of Aviation Week, for more than 10 years now. Great content. 

 

[Spekulatius]

@Xerxes thanks for the podcast recommendations. I will check them out.

 

I decided to flip my SAIC proceeds into BAH. Similar business but higher valuation and higher quality. I am simply going with the better LT track record here.