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
a 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 (
LMT
) 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 (
BA
) 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. Its balance sheet doesn't give me
anything. Its 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 (
NOC
) 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 hold it provides some ideas for
further research.
Happy hunting.
Disclosure:
Author owns NOC and SAI.
See also
Oneok Partners: Capital Appreciation Plus
Income
on seekingalpha.com