Tuesday, October 5, 2010

Soldiers of Fortune

With money market and bond yields at or near record lows, investors may do well to remember the old saying:

"The best defense is a good offense."

Given the valuations afforded to aerospace/defense companies these days, there may be yet another reason to keep it in mind.   At at time when bargains are getting harder to find, value investors would do well to look at this beaten down sector.

Chances are, if your firm derives a significant portion of its revenues from the Department of Defense, your shares have come under considerable pressure.  Such are the concerns about federal budget cuts.  Given the track record of such claims, the investment community should perhaps be a bit more skeptical.

Let's face it.  Our government spends money.  They spend lots of it.  And a huge portion goes towards defense.  That spending will (no doubt) continue for a very long time. The world isn't getting any safer.

Whether it is maintaining the "old" or inventing the "new", today's defense contractors have many opportunities to reward shareholders while helping defend the country, from UAV's (unmanned aerial vehicles) to cyber-warfare.  In any case,  worries about a falling defense budget seem priced into the shares in question.  If the fears are overblown, the upside will be all the more dramatic.

Starting with the balance sheet, defense companies are in great shape.  Companies like Raytheon (RTN), Cubic (CUB), and Flir Systems (FLIR) actually sport net cash on their respective books.  But even those with net debt are very conservatively financed.  Northrop (NOC) and General Dynamics (GD) were among the "worst" with debt at around 12 percent of their market values.  Among the smaller contractors, Harris (HRS) and L-3 Communications (LLL) have higher debt to market value ratios.

It appears, however, that the positives and negatives largely balance out throughout the defense sector.  While HRS and LLL have higher relative debt levels, they do not share a liability that most of the others do - a substantial pension liability.  Raytheon (again, one of the most conservatively financed of the group) has one of the worst pension situations (at nearly $5 billion underfunded).  Lockheed gets the dubious crown in this category with a pension benefit obligation nearly $11 billion higher than current plan assets.  Nonetheless both companies have been contributing to their plans in recent years.  And free cash flow multiples (inclusive of these pension costs) are STILL in the single digits.  The good news too is that pension liabilities are very long-term and it seems that the companies are being proactive in bringing their funding situations under control.  Unlike the auto industry, defense companies have the means to close the gap.  

Free cash flow is healthy across the board.  Those with the lowest free cash flow multiples are: L-3, Lockheed, Raytheon, and Harris.  Those with relatively high fcf multiples (low fcf yields) would be Flir, Rockwell Collins (COL), Cubic and Goodrich (GR).  Among the cheaper companies, dividend yields of over 3 percent are easy to find.

It says a lot that even Boeing looks expensive in this group.  The valuation bar is just that low.  In fact, BA really doesn't distinguish itself (valuation-wise) from the group in any way.  It's balance sheet doesn't give me anything.  It's pension isn't exciting (or very scary).  And it trades at a premium multiple to the group.  And having owned Boeing (successfully) in the past, I'm happy to have viable alternatives to this company and its exposure to commercial aviation.  Is the 787 flying yet? 

After adjusting for pension liabilities, net debt/cash, etc, Boeing isn't the only one that fails to distinguish itself from group.  Lockheed's debt and pension liabilities push it well into the middle of the pack on a valuation basis.  Goodrich and Rockwell fail too.

Of the larger integrated companies, Northrop is my favorite.  It's probably made the most pension progress in recent years thanks to considerable plan contributions.  Its funding situation is vastly improved.  The company has shown a penchant for selling non-core assets and for opportunistically repurchasing shares.  Net debt plus pension liabilities is very modest at under $5 billion.  The company trades at around 9 times free cash flow with a very handsome 3-plus percent dividend yield.

Among the smaller firms, I favor SAIC (SAI), which is exposed to some of the sexier areas within defense like cyber defense and intelligence.  The company has a healthy free cash flow yield of approximately 10%, little net debt, and an itty bitty (a technical term) pension liability.  The company is small enough to be considered a buyout candidate.  But this hasn't caused it to shy away from repurchasing shares.  The company's portfolio of strengths will ensure plenty of business in the years ahead.

If forced to pick a runner up in both categories, it would have to be Raytheon and Harris respectively.  Raytheon's high free cash flow, dividend, and balance sheet more than offset a sizable pension liability.  Harris shares many size and valuation attributes with SAIC, but with a different focus.  It could also find itself on the receiving end of a buyout.

In any case, while many sectors have been on a roll lately, most defense companies are hovering around their 52 week low.  This post is far from comprehensive, but I hope it provides some ideas for further research.

Happy hunting.

Disclosure:  Author owns NOC and SAI.


  1. Sorry to post here but didn't know how else. Any opinion on NPK? They do have a defense products segment. Would you be willing to do a writeup on it?

  2. I owned NPK until recently. I've decided to focus on more dedicated/integrated defense companies. NPK is very interesting, but management is not accessible. Love the dividend, but think the appliance business will be weak here. So I'm moving on to pastures I think are greener. NPK's defense business is focused on ammunition, which I think may be one of the weaker areas of defense (for now).