Author Topic: Defense contractors  (Read 3293 times)

KJP

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Defense contractors
« on: March 28, 2020, 03:56:34 PM »
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

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Re: Defense contractors
« Reply #1 on: March 28, 2020, 06:13:16 PM »
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

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Re: Defense contractors
« Reply #2 on: March 28, 2020, 07:03:57 PM »
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



« Last Edit: March 28, 2020, 08:36:12 PM by KJP »

scorpioncapital

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Re: Defense contractors
« Reply #3 on: March 29, 2020, 01:33:53 AM »
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

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Re: Defense contractors
« Reply #4 on: March 29, 2020, 01:46:41 AM »
I bought some VEC and VSEC on recent lows.
« Last Edit: March 29, 2020, 05:21:48 AM by meiroy »

Spekulatius

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Re: Defense contractors
« Reply #5 on: March 29, 2020, 04:55:01 AM »
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.
Life is too short for cheap beer and wine.

Cigarbutt

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Re: Defense contractors
« Reply #6 on: March 29, 2020, 07:39:18 AM »
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

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Re: Defense contractors
« Reply #7 on: March 29, 2020, 07:48:25 AM »
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

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Re: Defense contractors
« Reply #8 on: March 29, 2020, 08:01:58 AM »
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.
Life is too short for cheap beer and wine.

Cigarbutt

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Re: Defense contractors
« Reply #9 on: March 29, 2020, 08:30:00 AM »
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.
« Last Edit: March 29, 2020, 08:33:00 AM by Cigarbutt »