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Will Budget Cuts Squeeze Defense Contractors?

Contractors with the strongest competitive advantages will still be able to generate returns for shareholders despite budget pressures, say Morningstar's Anil Daka and Rick Tauber.

Jeremy Glaser: For Morningstar, I am Jeremy Glaser. There is lot of question marks surrounding defense companies. I am here with the Anil Daka, he is an equity analyst, and Rick Tauber, he is a credit analyst, to take a closer look at the sector and see where investors may find value today.

Gentlemen, thanks for joining me today.

Anil Daka: Good to be here.

Rick Tauber: Thank you.

Glaser: Anil, I'm going to start with you and want to ask you what's your general take on the defense industry right now with potential budget cuts coming with the new secretary of defense. Do you think that a lot of defense firms are going to be feeling the squeeze?

Daka: Yeah. The defense stocks are in a very interesting situation right now. On one hand, it's a case of where everybody knows the defense budgets are going down. But again, at the same time what the market has done is to push that stocks down so much that there are very good firms trading for 10 times earnings or even lower. So, it's an interesting mix of a situation where the market has kind of overpriced for risk at some level. So we do have a couple of high-quality stocks, such as Lockheed Martin and General Dynamics, that we think are undervalued. But again, as you rightly mentioned, it's not the best industry if you're looking for strong growth right now.

Glaser: So, what are some of the headwinds you think that these firms could see to their growth?

Daka: So, to start off, obviously just given where the federal deficits are right now, it's just a series of options of whether you want to cut some of those entitlement programs or do you want to touch defense. And arguably, defense is not going to escape the cuts irrespective of who is going to come in power right now. Even within the defense budget, what's happening is that, if you kind of look and breakdown how the government spends its defense budget itself, you have a people part of budget where you're paying for the salaries and health-care expenses of the troops and also the troops that had served earlier. So, some of those expenses are growing much faster than the regular inflation rate. So, you have a squeeze on the overall size of the defense budget itself, and even within the budget, there is a squeeze on the arms and procurement budget. So, the contract is kind of seeing the double whammy of trouble.

Glaser: Now, it doesn't look like the world is going to become suddenly peaceful anytime soon, so is that going to mean there is always a business there but just not going to grow as fast? It's going to be smaller?

Daka: Right. Again, there are multiple hotspots in the world. Look at the Far East, the China-Taiwan situation, and South Korea-North Korea. You have obviously the situation in Iraq and Afghanistan, and then you have the Middle East. There are way too many hotspots in the world. But at the same time, the U.S. has been traditionally the largest spender of defense by far, and with these contractors we're talking about, for them to be healthy, you need the United States defense budget to be healthy. The only defense budgets in the world that are growing at this point are the ones in place like China and Russia, and that's not the kind of countries that U.S. would want to sell any weapons to obviously for political reasons. So, it's kind of the defense industry per se will be around for, as you mentioned, forever perhaps. It's just that the growth has kind of come down, and it's a sector that's starved for any good news right now.

Glaser: So it kind of brings up this point of competitive advantages. Will they be able to keep these advantages over time? I mean, where do you think about the moats of these defense companies?

Daka: So, as you would expect in any sector, there are some firms with very strong competitive advantages which at Morningstar we designate as wide moats. The ones with the wide moats in the defense sector are Lockheed Martin and General Dynamics. Now, each for its own unique situation, what happened is during the last 20 years or so the industry kind of went through a large mergers and acquisitions boom, so there are some very specific capabilities where the United States government is dependent on sole contractors.

So, where the intensity of the competition is low enough that there are some firms with very distinct competitive advantage. Take for example Lockheed Martin. So, Lockheed is probably the only firm in the world that has a capacity to make a fifth-generation fighter jet. So, the next time the United States has a requirement to make that kind of a weapon, Lockheed is probably the only good contract for them. Or nuclear submarines, that's a very important component of the United States defense, and General Dynamics is the only one that makes those nuclear submarines right now. So, there are some parts within the defense where the firms have a distinct advantage, and these are the firms which we would expect to see the benefit of sticking around for long enough and enjoying that competitive advantage.

Glaser: So Rick, let's take a look at the credit side of the picture now. Suddenly, these competitive advantages are going to affect your ratings and your analysis. How do you take everything that's going around the industry into account when you're coming up with the creditworthiness of these firms?

Tauber: Sure. Just addressing the moats for example, Lockheed and General Dynamics with the wide moats, also not coincidentally have the highest ratings in our universe at A+. But kind of looking throughout the space, there is a number of things on which we have to focus. One is, as Anil highlighted, we have a lot of cheap equities out there. That means management teams are going to try to figure out ways to improve the stock valuations which often can go at the determent of the creditor. So, we have to be aware of that. One of the things we've done is take our models and stress-test them; we've factored in things like additional share repurchases, dividends, and acquisitions to kind of stress-test our ratings.

So the ratings we have are typically about a notch lower than where the model-driven rating would suggest as a result of some of these other ancillary things going on and potential risks to credit investors. But that said, we still think there is probably more downside risk here to our ratings than upside.

Glaser: So you're not terribly excited about the credit risk-reward trade-off you're getting from buying some of these bonds right now. If you looked on a relative basis, do some look a little bit better off than others?

Tauber: Sure, and I would say the sector is kind of trading at, what I'd say, around fair value actually for where our average rating is around A, and the Morningstar A index is trading maybe 5 to 10 basis points inside of defense. So we think it's kind of fairly valued. But within the sector we've looked at where the individual bonds are trading, of course.

Again, Lockheed with an A+ rating has a bond due in 2019, that's trading slightly cheap to bonds of competitors like Raytheon and Northrop which are a notch lower at A ratings, so we like Lockheed, relatively speaking. Then we also like BAE Systems, which is a little bit different from the rest of the group because it has a much more diversified business mix. It is based in the United Kingdom. About half of its business is to the U.S. Department of Defense, but it also has a lot more foreign government diversification including places like India and Saudi Arabia. We have the firm rated weak A, but those bonds trade about 50 wide of Lockheed's, for example, for its 2019 bond. So, we think those are the cheapest among the group and actually have the firm on our Best Ideas list.

Glaser: Anil, when you're looking across the equity universe, you mentioned some stocks that were cheap. What's your favorite idea for investors looking to get equity exposure to the sector?

Daka: So, if you want to invest, to start, we do not have a 5-star call. So, we still do not have that margin of safety we typically look for when we value for stocks. But that said, purely from evaluation standpoint, General Dynamics and Lockheed Martin are both wide-moat names. Both of them have a strong diverse portfolio of products that will get these firms through that weakness in the defense budget we spoke about, and the market is definitely overcompensating for that risk of that budget slowdown. Those two are very good names, I think.

Glaser: Anil, Rick, thanks so much for taking the time today.

Tauber: You're welcome.

Daka: Thanks.

Glaser: From Morningstar, I am Jeremy Glaser.


Jeremy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.