Industry faces short-term challenges, but discipline and strong balance sheets will get companies through.
This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.
Budget cuts and the winding down of wars in Iraq and Afghanistan have many investors wary of the defense industry. To find out whether defense companies can handle these near-term challenges and whether they will have long-term consequences for the industry, I sat down with Neal Dihora, a Morningstar equity analyst who covers industrials, and Rick Tauber, who is Morningstar’s director of corporate-bond research. Our discussion took place April 10.
Basili Alukos: The president released his budget this month, and there’s been a lot of talk about the size of the defense budget. Neal, before we dive in to the sector, how big is the defense budget?
Neal Dihora: The base defense budget is around $530 billion. We’ve seen that number stagnate for about the past three to four years. That does not include war funding, which they designate as “overseas contingency operations.” That’s been running all over the map. We’ve seen it as high as $187 billion. This year, we think it’s going to be closer to $90 billion, or less. We’ve withdrawn from Iraq, and Afghanistan is supposed to be done by the end of 2014. We maxed out the overall defense budget at almost $700 billion in 2010 when we had the surge in Iraq.
Alukos: What about the effects of sequestration and the implications of longer-term defense spending in light of our government looking to cut costs?
Dihora: There’s this misperception in the marketplace that defense is going to get cut by $1.2 trillion over 10 years. If you look at the raw numbers and assume that the fiscal 2013 baseline defense budget was $530 billion, even after sequestration, we’ll have $480 billion of spending to do. It’s a real cut of 9% in the interim, and then we get back to $500 billion by 2016. We’re not really cutting $1.2 trillion out of anything. We’re $1.2 trillion from a trend baseline that was created before. The sequester brings us to a new baseline. So, we’re going to start from that $530 billion, we’re going to cut what we think needs to be cut in one or two years, and then we start growing again.
A new baseline is not the worst thing for defense contractors, as long as they’re able to manage their costs to it. They’re not in the same situation that they were in the 1990s, which is when the last big defense cuts happened, what the industry calls the “Last Supper,” when 15 industry CEOs were told by the Department of Defense that the budget was being substantially cut post-Gulf War I.
Companies started consolidating, took on a lot of debt, and before 9/11 happened, they were struggling. We circle to today, and there are only five prime defense contractors: Boeing BA, Lockheed Martin LMT, General Dynamics GD, Raytheon RTN, and Northrop Grumman NOC. None of these players has a whole lot of debt. They’re in a position of pretty strong financial strength. If they can manage their cost base to the revenue opportunity, I think the stocks are going to be pretty interesting.
Alukos: Rick, how do defense companies look from a credit perspective?
Rick Tauber: They’re all A/high BBB, which is solidly positioned in investment-grade. The recent trends ahead of the sequester have made it very impressive to maintain that credit quality. I view their credits as stable, with potential margins coming down and revenues under pressure. But these guys are being very disciplined financially and have built up cash on their balance sheets, so most of them have modest net-debt positions. They still have strong free cash flows, which gives them the flexibility to manage their balance sheets.
One thing I’ve focused on is how disciplined will they be to not make big acquisitions, or not do massive share-repurchase programs to re-lever up the companies and feed shareholders that excess cash. As the stocks hold up, the credits will also hold up, because they won’t need to do anything extreme.
The other trend that I’ve noticed in some of these companies is rather than acquiring, they’re splitting off divisions. L-3 Communications LLL split off Engility. Engility is now a junk credit, but L-3 has maintained its investment-grade ratings. SAIC SAI has got plans to split into two companies, one of which will remain an investment-grade company and the other a junk-rated company. The split-offs tend to be the companies with the worst business positions; they think they can put a little bit of leverage on and continue to generate good cash flows.
You also saw Northrop split out Huntington Ingalls HII, its shipbuilding unit. We’ve seen portfolio paring, a focus on profitability, rather than doing some of the more potentially extreme and risky measures in the sector. That speaks to the health of the sector and the management teams that are in place right now.
Alukos: Let’s talk about individual stocks. Full disclosure: I own General Dynamics. It’s a name that I think is interesting, at least from a valuation perspective.
Dihora: GD is a favorite of ours, too. People aren’t expecting much out of the company. One of the reasons is that in the last couple of quarters, it has run into execution issues. Some of it is its own doing. Some of it’s not. But they’ve done a lot of acquisitions over the past 10 years, and some of them have not been integrated well.
About a quarter of GD’s business comes from the U.S. Army in their combat division. With the pullback from both Iraq and Afghanistan, that division has struggled and will continue to struggle. But the fascinating thing is that when we model these struggles, we still get a pretty attractive value.
The positive side of GD is half of its business is solidly covered by a large sustainable competitive advantage.
Gulfstream Aerospace business jets are 25% of GD’s business, and that has nothing to do with the Department of Defense. Corporate private jet usage in the United States will hit a new all-time high in the first quarter of 2013. The number of millionaires in the world also has hit a brand-new high. These trends will be good for General Dynamics. Their business jet serves the high end of the market.
The other solidly profitable segment of GD is its marine division, which primarily sells to the U.S. Navy. They’re one of two companies within the United States that offers these services. The other one is Huntington Ingalls. President Obama’s and the Department of Defense’s shift to the Asia theater away from the Middle East is good for the Navy. We don’t have countries that we can just naturally go to. Japan has been back and forth on whether they’re going to allow us to have a base there. We have bases in Korea and Australia, but if we really want to target the trading channels in the Asian theater, we need a strong navy.
So, I think over time the Navy will get better funding, and there are only two players that can provide these goods: General Dynamics and Huntington Ingalls. These are massively long-cycle programs. It takes two years to build a sub. The funding of these programs is generally long-dated. It’s almost embedded in Congress’ numbers, and they really don’t change all that much.
The final division that GD has is information technology. The entire defense industry has struggled with IT. We think it’s more of a federal government spending issue than it is company-specific. But GD, to its detriment, has done a lot of acquisitions over the past 10 years in this division, and it has not successfully integrated them. We think the firm’s incoming CEO, Phebe Novakovic, is going to take significant action. GD’s shares are attractively priced because people are waiting for the execution to show up. They see a new manager coming in. They see issues that have been happening for the past couple of quarters. They see an admittance of a process that’s broken in terms of acquisitions and integrations. So, why pay for it here? This is where the opportunity lies. Because here you have a company that generates a ton of money, that’s got half its business in solid growth mode, and you’re getting paid to take the risk on the other two sides.
Alukos: What else is out there besides GD?
Dihora: Most of our defense stocks are rated 3 stars, meaning they are fairly valued based on our estimates. But investors looking for yield should look at Lockheed Martin. It has a 5% yield.
Lockheed Martin is a company that is the largest defense contractor in the world. Most of the headline risk comes from the next generation military aircraft, the F-35, where we have a back-and-forth in Congress about funding and not funding it. But Lockheed has broad exposure to different areas. It has Navy businesses, it has Air Force businesses. It has some Army business, although it’s not much. It has a strong international component. The company isn’t really going to lose a whole lot in terms of sequestration, but it will be affected by it, just like all the other players. But with its size and cash flows, I wouldn’t expect its yield to go down.
Alukos: What about Boeing? The company has been in the news a lot with the 787. How much of its success is tied to the 787?
Dihora: People think of Boeing as more of a commercial airline company than a defense company. A couple of years ago, the split was 50-50; it actually used to get slightly more operating dollars from defense than it did from commercial aerospace. But that was mainly due to the delays with the 787. It was delayed more than three years. One was finally delivered in September 2011, and then it was grounded on Jan. 16 due to battery fires.
The 787, at its current point, is a detriment to operating profit margins. We think it will be three to four years until Boeing starts making money on an actual cost and revenue basis. Boeing will make a low single-digit number like 2% operating margin on the 1,100 aircraft it will produce in the next 10 years. That’s about $4 billion to $5 billion in total. Last year, the company posted operating profit dollars of $6.3 billion. The initial 1,100 deliveries of the 787 are not going to be all that meaningful.
But this is not atypical of new programs. In three to four years, the 787 is going to be a huge generator of revenue. The balance sheet will get better, because right now they’re holding a lot of this stuff on inventory. When it starts delivering the planes, the balance sheet will finally start shrinking, and it will actually generate some cash flows.
Tauber: In the meantime, Boeing is cranking out 737s and 777s. I don’t see a problem in the balance sheet. I don’t think anybody questions the viability of the 787 and the differentiation it has as a product. It’s just taking a long time to get there.
Dihora: Yes, but if you think the aerospace or aircraft business will turn down in any way, defense is not going to come to the rescue, per se. We forecast the defense side to be flat to down 2% to 3%. I don’t see a resurgence really helping them all that much. It’s mostly a commercial-focused company.
Our fair value estimate of Boeing is $80. It is negatively impacted by Boeing’s massive pension deficit. We treat the pension just as straight debt, or as a proxy for debt. If you told me that the discount rate that Boeing was going to use was going to go up by 100 or 200 basis points, our fair value would go up significantly. For right or wrong, that’s the way that we look at the company. Unfortunately, Boeing uses a 3.8% discount rate, as of December, for its pension obligation valuation. I think it raised the amount that it owes in the future by about $3 billion, which is a huge number.
We just said that $6.3 billion was how much operating profit Boeing generated in 2012. This discount rate change made them owe more than $3 billion in just their pension over the next however many years. So, discount rates have a material impact on our fair value estimates going forward.
Alukos: Okay. We’ve discussed a lot. Can you give us a quick sum-up of the sector?
Dihora: Worries about defense cuts and the sequestration are relevant, but they’re overplayed in the media, because what sequestration really does is just to reset the bar, and then we can move forward to growth. That’s the important takeaway for me. Yes, we’re going to have an issue in 2013 and maybe part of 2014. But we’re talking about an issue that lasts for two to four quarters at best.
If we can get the flexibility from the defense contractor’s point of view, if companies can cut costs to meet the new revenue bar, then they’re going to be fine. Their balance sheets are pretty solid, and they’ve been shareholder friendly, so I really don’t see a huge downside risk in these names.