Despite the upcoming defense budget austerity, there are two companies well positioned to return excess returns on capital for the long-term oriented investor.
Defense Industry Sequester
Inevitably viewed as a negative drag on the economy and the defense industry, the upcoming budget cuts could seriously dampen the outlook for several defense stocks. According to a Morningstar article published March 4, 2013 (source: here):
"It cuts $1.2 trillion in budget authority over 10 years, starting with $85 billion this year, split about evenly between defense spending and discretionary spending (just about everything besides Medicaid, Social Security and, for the most part, Medicare). The law makes no distinction between desirable cuts and undesirable cuts-everything takes a hit. The design was intentionally blunt, since sequestration was supposed to be so unpalatable to both parties that they would be forced to make tough, but reasoned, choices about spending cuts. Unfortunately, they didn't do so."
To more clearly define the "budget cuts" the author states:
"First, the cuts are to budgetary authority-what departments are empowered by Congress to spend-but these may not equate to what they were planning to spend in the first place. A more accurate way to think of the size of cuts is that the dollar amounts reflect the value of substitute cuts Congress would have to come up with in order to replace those in the sequester."
While I would not say the effects of the sequester are overblown, for the investor focused on long term-capital appreciation looking for defense exposure, two companies could continue to perform well in the upcoming decade: Huntington Ingalls (HII) and General Dynamics (GD).
Huntington Ingalls Industries, Inc. (source: 10-K)
For more than a century, Huntington Ingalls Industries, Inc. has been designing, building, overhauling and repairing ships primarily for the U.S. Navy and the U.S. Coast Guard. It is the nation's sole designer, builder and refueler of nuclear-powered aircraft carriers, the sole builder of amphibious assault and expeditionary warfare ships for the U.S. Navy, the sole builder of National Security Cutters for the U.S. Coast Guard, one of only two companies currently designing and building nuclear-powered submarines for the U.S. Navy and one of only two companies that builds the Navy's current fleet of DDG-51 Arleigh Burke-class destroyers. It is the exclusive provider of Refueling and Complex Overhaul services for nuclear-powered aircraft carriers, a full-service systems provider for the design, engineering, construction and life cycle support of major programs for surface ships and a provider of fleet support and maintenance services for the U.S. Navy. The primary areas of business include the design, construction, repair and maintenance of nuclear-powered ships, such as aircraft carriers and submarines, and non-nuclear ships, such as surface combatants, expeditionary warfare/amphibious assault and coastal defense surface ships, as well as the refueling and overhaul and the inactivation of nuclear-powered ships.
Operational Unit Breakdown
% of Total Sales
Ingalls - design and construct non-nuclear ships for the U.S. Navy and U.S. Coast Guard, including amphibious assault ships, surface combatants and National Security Cutters
- Amphibious Assault Ships - sole supplier to the U.S. Navy of amphibious assault and expeditionary warfare ships
- Surface Combatants - design agent for and one of only two companies that constructs the DDG-51 Arleigh Burke-class guided missile destroyers as well as major components for the DDG-1000 Zumwalt-class of land attack destroyers
- National Security Cutters - The U.S. Coast Guard's recapitalization program is designed to replace aging and operationally expensive ships and aircraft used to conduct missions in excess of 50 miles from the shoreline. The flagship of this program is the Legend-class NSC, a multi-mission platform designed and built by HII.
- Fleet Support - Fleet support provides comprehensive life cycle services, including depot maintenance, modernization, repairs, logistics and technical support and planning yard services for naval and commercial vessels through the AMSEC and CMSD subsidiaries
Newport News - extends from the core nuclear business of designing and constructing nuclear-powered ships, such as aircraft carriers and submarines, and the refueling and overhaul and the inactivation of such ships, to secondary businesses that are focused on the construction of heavy manufacturing equipment for commercial nuclear power facilities and the operations, management and cleanup of environmental hazard sites through Department of Energy ("DoE") programs:
- Aircraft Carrier Inactivation
- Design and Construction of Nuclear-Powered Submarines - one of only two companies in the United States capable of designing and building nuclear-powered submarines for the U.S. Navy
- SSBN(X) Ohio-Class Replacement Program - The U.S. Navy's shipbuilding plan for Fiscal Year 2013 states the U.S. Navy's intention to focus on the design and construction of replacement boats for the current aging Ohio-class nuclear ballistic and cruise missile submarines
- Savannah River Nuclear Solutions, LLC - In January 2008, SRNS, a joint venture with Fluor Federal Services, Inc. and Honeywell International Inc., was awarded a five-year $4 billion contract for site management and operations of the DoE's Savannah River Site located 12 miles south of Aiken, South Carolina
- Newport News Industrial Corporation - NNI provides a range of support services to operating commercial nuclear power plants
General Dynamics (source: 10-K)
General Dynamics is an aerospace and defense company that offers a broad portfolio of products and services in business aviation; combat vehicles, weapons systems and munitions; shipbuilding; and communications and information technology. GD operates through four business groups: Aerospace, Combat Systems, Marine Systems and Information Systems and Technology.
- Aerospace - designs, manufactures and outfits a comprehensive family of Gulfstream business-jet aircraft, provides aircraft services (including maintenance and repair work, fixed-based operations (FBO) and aircraft management services) and performs aircraft completions for aircraft produced by other original equipment manufacturers (OEMs).
- Combat Systems - a global leader in the design, development, production, support and enhancement of tracked and wheeled military vehicles, weapons systems and munitions for the United States and its allies.
- Marine Systems - designs, builds and supports submarines and surface ships. One of two primary shipbuilders for the U.S. Navy.
- Information Systems and Technology - provides critical technologies, products and services that support a wide range of government and commercial communication and information sharing and security needs. The group consists of a three-part portfolio centered on secure mobile communication systems, information technology solutions and mission support services, and intelligence, surveillance and reconnaissance systems.
Operational Unit Breakdown
% of Total Sales
Historically, all of HII's sales have been government-based, with the Navy comprising 96-97% and the Coast Guard the balance.
In 2012, 66% of GD's revenues were from the U.S. government, 13% from U.S. commercial customers, 8% from international defense customers, and the remaining 13% from international commercial customers.
GD has a bit more a diverse customer base than HII. The commercial business jet segment has experienced average annual growth of approximately 15% since 2010 and should continue to benefit from an increase in millionaires and overall wealth in the U.S. Additionally, exposure to international markets offers a larger and more diverse customer base. However, its largest segment, IT&S is also its weakest, with expected continued decline in revenue with upcoming budget austerity.
As of December 31, 2012, HII's backlog was roughly 16 billion dollars, of which 31% is expected to be converted into sales in 2013.
As of December 31, 2012, GD's backlog was roughly 51 billion dollars, of which 53% is expected to be converted into sales in 2013.
The landscape is very fragmented as HII and GD primarily compete with each other. The limited number of suppliers, long project cycle time, high barriers to entry, and ability to share projects among competing firms should create the ability for both companies to earn excess returns on capital.
HII is the only company currently capable of building, refueling and defueling the U.S. Navy's nuclear-powered aircraft carriers and should be in a strong competitive position to be awarded each contract to perform such activities. Additionally, it is currently the only builder of large deck amphibious assault and expeditionary warfare ships for the U.S. Navy, including LHAs and LPDs, and are positioned to be awarded future contracts for these types of vessels. Lastly, HII is the sole supplier of NSCs for the U.S. Coast Guard, and is positioned to be awarded future contracts for these types of vessels
GD competes against other large platform and system-integration contractors as well as smaller companies that specialize in a particular technology or capability. Internationally, GD competes with global defense contractors' exports and the offerings of private and state-owned defense manufacturers based in the countries where it operates. GD's Combat Systems group competes with a large number of domestic and foreign businesses. The Marine Systems group has one primary competitor with which it also partners on the Virginia-class submarine program. The Information Systems and Technology group competes with many companies, from large defense companies to small niche competitors with specialized technologies. The operating cycle of many of GD's major platform programs can result in sustained periods of program continuity when we perform successfully.
The obvious risk factor is the dependency on a single customer, the U.S. Government. This provides an enormous advantage in terms of buyer power. Additionally, the upcoming budget cuts represent a challenge for the industry in general. Additionally, overcapacity in U.S. Shipbuilding could potentially dampen expected contract revenue into the future. The reduced level of shipbuilding activity by the U.S. Navy, evidenced by the reduction in fleet size from 566 ships in 1989 to 288 ships as of December 31, 2012, has resulted in workforce reductions in the industry but little infrastructure consolidation. The general result has been fewer contracts awarded to the same fixed number of shipyards. Six major private United States shipyards, three of which are HII shipyards, plus numerous other smaller private shipyards compete for contracts to construct, overhaul, repair and convert naval vessels. As a result, HII has announced its intention to cease all military shipbuilding operations in its Louisiana facilities by the end of 2013.
Since its IPO, HII has experienced mixed results. 2011 was a difficult year as product sales decreased 2% from 2010, driven primarily by lower revenues in Surface Combatants, partially offset by higher revenues in Amphibious Assault Ships. In 2012, product sales increased 1%, which included a slight decline in Amphibious Assault Ship sales, partially offset by higher sales in Surface Combatants. Service revenues in 2011 decreased 3%, but increased 6% in 2012.
Over the last ten years GD has shown excellent margin expansion and revenue growth. However, since 2010, margins have contracted and in 2012 GD experienced a net loss in earnings. This was driven by the Information Systems and Technology's mobile communication systems business and on several international wheeled vehicle contracts in the Combat Systems group. These decreases were partially offset by higher revenues in the Aerospace group due to increased deliveries of G650 aircraft. Operating costs increased in 2012 due, most significantly, to the $2 billion goodwill impairment recorded in the Information Systems and Technology group. This impairment of goodwill was due to expected decreased defense spending in this segment (source: press release).
GD's EPS prior to 2012 has been steadily climbing. The impairment charge in the IT&S segment severely affected full year performance, causing the stock to fall from $70 to $65 in the coming days after the announcement. The stock has since recovered and appreciated further, mitigating any ability to purchase at a discount for the one-time adjustment.
Typically, I look for Free Cash Flow as a percentage of sales greater than 5%. In its short time as a public company, HII has been moderately successful, with FCF/Sales of 5% in 2011. Furthermore, GD has consistently converted at least 5% of its sales into FCF, although at a lesser pace over the last 3-4 years. Importantly, the company remained free cash flow positive during 2012.
A company's value is determined by the present value of its expected future cash flows. For this reason, I focus heavily on free cash flow generation. Both companies are FCF positive, which is a good sign. The fragmented market and limited suppliers as competitors bodes well for the companies' ability to generate excess FCF and returns on capital into the future.
The above table shows favorable forward P/Es and HII currently trading at a PEG ratio less than 1.0. An internal growth rate of 17.24% was calculated based on the retention rate*ROE. It is currently difficult to compare GD given its negative EPS for 2012.
Total Debt/Op Income
Liabilities/SE + Tres. Stock
The benchmarks are subjective based on Pat Dorsey's The Five Rules for Successful Stock Investing and represent the cream-of-the-crop type stocks. Adjustments can be made as necessary given differences in industries. Here, HIII and GD are relatively comparable. GD has a large advantage in terms of the amount of Gross Profit it spends on SG&A (44.6% vs. 68.49%) but has recently spent more in CapEx. Both firms have solid interest coverage for moderate-to-highly levered firms.
December 31, 2012 EBIT
-Cash & Equivalents
Industry Ave (GuruFocus)
December 31, 2012 EPS
Based on the most recent 10-K as of December 31, 2012 and an industry average 14.7 EV/EBIT figure (source: gurufocus.com), the value of HII is $70.52 and GD is $23.62. Obviously, a large grain of salt needs to be taken with GD given its poor 2012, which was uncharacteristic of its 5 and 10-year operating performance. HII is currently undervalued and represents a 10-12% upside based on this valuation technique. Furthermore, based on an industry average P/E ratio of 18 (source: Morningstar), HII is slightly overvalued at a current P/E of approximately 20. GD trades at a negative P/E based on its full year net loss. To get a clearer picture on values, I used the most recent filing and annualized the figures and applied the same valuation model.
-Cash & Equivalents
Industry Ave (GuruFocus)
By consulting the most recent filings and annualizing the EBIT and EPS figures, I was able to come up with a more current and realistic approach to valuation. Based on the annualized EBIT and industry average multiple of 14.7, the fair value estimate of HII is $76.14 and GD is $140.22. This represents a 17-18% upside opportunity for HII and approximately 40% for GD. Based on annualized EPS figures and industry average EPS of 18, HII is currently fairly priced while GD is approximately 30% undervalued.
GD's 2013 outlook for Aerospace calls for a 16% increase in revenue. The Combat Group is expected to decline 6% while Marine Systems (+2%) and IS&T (-5%) are also mixed. While the stock has already recovered from poor annual earnings, including the $2 billion impairment write down, and continued decreases in defense spending could dampen returns for both companies. GD's wide array of products helps mitigate some negative effects of this. The commercial jet business commands nearly 30% of the market share according to Morningstar's research analyst (source: here) and the number of jet deliveries has climbed steadily since 2009. The combat systems division's crown jewel is the Abrams tank, with a life until 2050 that will command future spares and parts during that time. International orders should see increased demand as well. The marine duopoly between HII and GD should continue to benefit both companies as Navy spending and marine expenditures is expected to continue into the future with the recent announcement of an increased presence in Asia. IS&T is the largest revenue source for GD and represents the biggest challenge. With budget cuts looming, this environment will remain challenging. For this reason, I would take a haircut on the above valuation to the tune of 20%, representing a fair value price of $96-112, with a larger margin of safety, representing a purchase area of $72-84.
HII is more a pure play on the Navy, which I expect to be more robust and less affected than Army and Air Force spending as fewer resources are put into Iraq and Afghanistan. Furthermore, the company is roughly 10x smaller than GD, offering a small-cap advantage to retail investors. While information and research is more difficult to come by, making tougher work for investors, the ability for HII to increase its size and market capitalization is much easier than GD. On a valuation perspective, there is potential upside. Although less than GD, the required margin of safety in my opinion is less as well, making this stock a less risky pick over the long term. At a fair value range of $64-76 and a margin of safety of 20%, a fair purchase price would be $51-61, close to where the stock currently trades.
For any of you who are technically inclined, HII's up-channel pattern beginning in November can be attributed to the 50-day moving average. A pullback to this area and support would represent an excellent buy area around $57. As for GD, a channel breakout in July has pushed this stock into a technical 'hold' for me, and I would be more comfortable to see a successful test and support area around $80, with an excellent opportunity along the 200-day moving average around $70.