Was The Super Committee Relevant For Defense Contractors?

by: Bennington Investment Ideas

Much has been made of the failure of the super committee to achieve the targeted deficit reduction. According to the Budget Control Act of 2011 enacted on August 2, 2011, this failure will trigger mandatory cuts to defense and other areas. The projected cuts for defense are $600 billion over a 10 year period. There would also be another $600 billion cut from non-defense budgets.

During this time, the stock market has gyrated wildly with the SPDR S&P 500 Trust hitting a closing low of 109.93 on October 3rd. Despite a recent swoon, SPY is currently up almost 6% from that level. SPY has a closing peak of $128.63 on October 27th. The following stocks have also had their ups and downs since the passage of the Budget Control Act of 2011.

Select Defense Contractors

Ticker Name Annual Revenue ($millions) Beta
TDY Teledyne Technologies Incorporated $ 1,644 1.45
RTN Raytheon Company $ 25,183 0.81
LMT Lockheed Martin Corporation $ 45,803 0.88
HON Honeywell International Inc. $ 33,370 1.29
BA Boeing Company (The) $ 64,306 1.35
TXT Textron Inc. $ 10,525 2.71
NOC Northrop Grumman Corporation $ 34,757 1.12
GD General Dynamics Corporation $ 32,466 1.30
ACN Accenture plc. $ 27,252 0.82
SAI SAIC, Inc. $ 11,117 0.37

Source: Yahoo Finance.

Note: ACN has a fiscal close in August, and SAI has a close in January, so annual revenue is fiscal 2011 for both companies, while the others effectively show 2010 calendar revenue.

The first thing to note is that these stocks show varying levels of historical exposure to the market as measured by their beta. However, it is important to note the beta is a historical mathematical measure. SAI, which had the lowest beta, has also shown some of the largest swings. This is probably expected since it has a substantial portion of its business from the Department of Defense. The following table shows the dividend adjusted performance over varying time frames.

Dividend-Adjusted Recent Returns

Ticker Performance since failure announced (11/21) Performance from 10/27/11 Performance from 10/3/11 Performance from Act Enactment (8/2/11)
TDY -3.2% -13.4% 10.0% -2.5%
RTN -0.5% -1.5% 9.2% -0.7%
LMT 1.2% -0.3% 5.9% 3.4%
HON -4.2% -8.5% 16.9% -2.7%
BA -4.2% -6.4% 8.5% -6.0%
TXT -4.2% -13.8% 3.6% -17.4%
NOC -2.2% -6.5% 6.0% -5.4%
GD -3.1% -6.8% 10.7% -6.8%
ACN -2.5% -12.2% 5.3% -6.3%
SAI -1.6% -10.6% 0.8% -25.3%
SPY -2.8% -9.6% 5.8% -6.8%

Sources: Yahoo Finance; author calculations.

The first observation is that many of these stocks underperformed the market last week in wake of the announced failure of the super committee. However, many of these stocks have higher betas than the market as a whole. For example, GD underperformed -3.1% compared to -2.8% for SPY, but has a 1.3 beta suggesting one would expect a 30% under performance. In reality, it only had around a 10% under performance.

The next observation is that SAIC showed limited decline since the announced failure, but had substantial decline since the passage of the Act in early August. However, within days of the Act, TXT was down around 20%, while all the others had declines reasonably consistent with the broader market. It should be noted that TXT has a 2.7 beta suggesting it would experience high volatility anyways. A glance at its fundamentals also shows TXT has relatively high leverage among defense contractors, which contributes to its high beta.

The second observation is that since the passage of the Act and the subsequent failure of the super committee, many defense contractors have outperformed the market on both an absolute and risk adjusted basis. The only absolute under performance was from SAI and TXT. TXT and SAI are also relatively smaller and more exposed companies; however, not as small as TDY.

TDY does have a single sector focused on Aerospace and Defense that accounts for about 30% of its revenue. In contracts, SAI also has four segments, including a Defense Solutions segment which represents about 40% of its revenues. In addition, its Health, Energy and Civil Solutions and Intelligence and Cybersecurity Solutions that effectively account for the rest of the business had the U.S. government as major customers.

TXT has a relatively heavy exposure to its Bell Helicopter segment. While Bell is about 35% of revenue, it contributes over 50% of operating profit. In addition, its Textron Systems segment, that also serves the military, contributes another 17% of revenue and 18% of operating income.

The following chart shows the relative performance of SAI, TXT and SPY:
Source: Yahoo Finance.

In addition, this shows that TXT performance occurred early on after the passage of the Act, while SAI suffered from a poor quarterly announcement with declining revenue. However, since that early September, TXT has outperformed the market while SAI has continued to fall.

It appears that TXT and SAI have the largest exposures and so an investor who follows government and defense spending with a contrary market perspective could do well in these stocks if they are correct. SAI might offer the largest promise. However this thesis is based on improving spending for SAI while the general market consensus is just the opposite.

The other interesting stock that surfaced in this analysis is TDY. From Yahoo Finance:

Teledyne Technologies Incorporated provides instrumentation, digital imaging products and software, aerospace and defense electronics, and engineered systems in the United States and internationally. The company's Instrumentation segment provides monitoring and control instruments for marine, environmental, scientific, industrial, and defense applications, as well as harsh environmental interconnect products.

Its Digital Imaging segment includes sponsored and centralized research laboratories benefiting government programs and businesses, as well as development efforts for innovative digital imaging products for government and space applications. It also includes infrared detectors, cameras, and optomechanical assemblies.

Teledyne Technologies' Aerospace and Defense Electronics segment provides electronic components and subsystems and communications products, including defense electronics, data acquisition, and communications equipment for air transport and business aircraft and components and subsystems for wireless and satellite communications, as well as general aviation batteries.

The company's Engineered Systems segment provides systems engineering and integration, advanced technology application, software development, and manufacturing solutions to space, military, environmental, energy, chemical, biological and nuclear systems, and missile defense requirements. This segment also designs and manufactures hydrogen generators, thermoelectric and fuel-cell based power sources, and small turbine engines.

Teledyne Technologies customers include government agencies, aerospace prime contractors, energy exploration and production companies, industrial companies, and airlines. The company was founded in 1960 and is headquartered in Thousand Oaks, California.

TDY caught my attention since it is a relatively small company with a reasonable forward P/E of 12.9x, based on analyst estimates. While it has some debt and is a little thin on cash, it is not overly levered. I would note that this is just a cursory glance and it is quite possible that there are some issues, but for an investor looking at defense contractors, this could be interesting since it is a contractor but also serves several other industries with specialized solutions.

My overall takeaway from this is that the super committee success or failure was just noise for the bulk of the defense contractors. The current posturing of future reductions in defense spending is not driving these stocks. However, there should be no mistake that actual reductions do impact the stocks as noted in the case of SAI. The notion that it is noise could be from four possibilities:

  1. The potential cuts would be spread around and being in the future are discounted already and so that impact is lost within all the other impacts on these companies.
  2. The super committee was expected to fail from the start and Congress can also unwind the legislated mandated cuts somewhere in the future and so the whole exercise was largely a waste.
  3. These companies are reasonably diversified (excluding TXT and SAI) which would further mitigate the impact as noted in item 1.
  4. Given the recent (around 10 years) massive increase in defense spending and rapidly deterioration in government finances, the market had already, well before August, priced in some notion of future defense spending cuts or perhaps even just slowing growth already.

This article does not advocate a long or short position on any specific stock; although, depending on your views, TXT, SAI and TDY might be interesting. I think it does highlight the complexity of how government behavior and machinations impacts stocks. Simplistic assumptions about the loss of future defense spending negatively impacting this broad class of stocks would most likely not have produced surplus alpha. In fact, one might have underperformed the market as a whole.

Disclosure: I am long SPY.

Disclaimer: This article is for informational and educational purposes only, and shall not be construed to constitute investment advice. Nothing contained herein shall constitute a solicitation, recommendation or endorsement to buy or sell any security.