The Best Defense: Sizing Up U.S. Defense Contractors
Defense spending is due to increase regardless of which party is in the White House, but the stocks of most contractors already look pricey.
Terrorism and armed conflicts are becoming a regular occurrence in certain parts of the world. Their impact has been heightened here in the United States during a particularly heated presidential election season that has partly centered on the country's standing in the global economy. It's natural to think that such rhetoric would lead to increases in defense spending on everything from next-generation submarines and airplanes to cyberwarfare technology, regardless of which candidate winds up in the White House.
Equity analyst Chris Higgins, who covers defense contractors for Morningstar, says that a lot of the campaign debate is largely noise, however. Indeed, a better barometer for defense spending is not what candidates say on their soap boxes, but rather an assessment of global threats and government deficits. Adding a layer to Higgins' analysis of U.S. contractors is a raft of spending on share repurchases and hefty dividends, which have helped push valuations above Morningstar's fair value estimates.
We recently sat down with Higgins to get his thoughts on the sector. His answers have been edited for length and clarity.
Rob Wherry: We are talking about defense contractors during an election year. I realize you don't have a crystal ball--and Morningstar doesn't weigh in on elections--but can you give readers an idea of how you assess the impact of having a Republican or a Democrat in the White House?
Higgins: It's a question we've gotten from a lot of clients. If you look at the historical data, it's pretty clear that elections don't matter as much as everyone thinks.
Yes, they matter at the margins. But it's more about: What's the threat environment look like and the public perception of that threat environment? What's the fiscal health of the U.S. budget--not the defense budget, the overall budget? Are we running deficits or surpluses? And what does the defense budget cycle look like? Are we at a trough in defense spending or at a peak relative to recent history? That's a much better predictor of a long-term view--four or five years out--of where the defense budget is going.
Wherry: That chest-pounding--the "I'm going to make the sand glow" comments--you process them, but you also chalk them up to more short-term rhetoric?
Higgins: If you're going to hold these stocks longer than, say, two or three years, then all that is noise. There will be a difference between a Donald Trump administration and a Hillary Clinton administration. If you look underneath what the defense spending is doing, you might see some differences there and some programs suffering and other programs winning to a certain extent.
But the other thing that really constrains a president's ability to shape the defense budget--and to pick winners and losers in terms of the programs that they're funding--is Congress. You look at a program like the F-35: Almost every state in the union is involved in this program. Senators and representatives in Congress have a vested interest in keeping this program alive. And a candidate like Trump comes out and kind of makes statements against the F-35 program. It's the largest program ever in the history of the Department of Defense. It's a fighter aircraft program. And he's made statements saying, "Well, I don't know if it's worth the money we're spending, and I think we should cut it."
I'm not quoting verbatim, but Congress is standing there saying, "Well, I have jobs in my district that are tied to this program." Setting aside whether it's a good program or not, they have a vested interest in this, and that constrains any administration. [The administration] proposes budgets, but it's Congress that, at the end of the day, passes it and then sends it back to the president and says, "OK, we've marked it up. We've decreased funding for these programs, increased for these programs. We didn't like what you did here." And then the president can decide whether they're either going to sign the bill or not or try to send it back to Congress. Most of the time, they just sign it. So [the administration] is also constrained by the way our system is set up.
Wherry: Let's leave the political realm and talk about other ways you evaluate defense firms' moats. The one area I am curious about is threat assessment. How do you look at that?
Higgins: I look at it in terms of what it means for share prices and defense firms' business. According to Gallup, about 37% of Americans polled think we spend too little on defense. That's shifted from a few years ago. So, when we talk about the threat environment, that perception has something to do with it.
In terms of factoring in the threat environment, we're not trying to get a crystal ball out and figure out the geopolitical situation. At the same time, it's very clear certain threats call for different kinds of weapon systems.
To give you an example, Russia really wasn't on the radar screen six or seven years ago in terms of a threat. That's changed with the Ukraine. What does that translate into? General Dynamics (GD) happens to be our top pick in the sector. Ground forces are in demand, especially across Eastern Europe. There is a big export potential there for General Dynamics, because it's a ground vehicle manufacturer. Before, ground vehicles were a bit out of fashion. But now you have a resurgent Russian threat. That could be potentially positive for a company like General Dynamics.
Wherry: Do you try to walk through how adversaries would potentially fight a conflict? For example, whether a country or a combatant would need ground vehicles or planes or ships depending on the geography?
Higgins: To a certain extent. I wouldn't say that we do a very detailed analysis of what that looks like.
But it's clear that if you have an asymmetric threat like ISIS, for example, that is not a near-peer competitor like China or Russia, the emphasis of funding is not going to be on high-end weapons systems like nuclear submarines. Whereas with Russia, it may be more focused on a program like the Ohio replacement program, where we're replacing our nuclear ballistics missile submarines. You can clearly see if you have an asymmetrical enemy, it's more focused on cybersecurity, intelligence, services, human intelligence, expendables like munitions--those areas.
Wherry: You anticipate the Department of Defense budget increasing 1% to 2% the next five or six years. Is that a healthy rate?
Higgins: If you look at the defense budget, it's actually lost share as a percentage of GDP over time. In the 1980s, it was a double-digit percentage of GDP. Now it's come down to 3% to 4% of GDP. Historically, it's grown slower than GDP. We've seen it growing more at a rate of inflation and lagging behind the nominal GDP number.
Wherry: So, the budget could grow at a much healthier clip than it did during the Obama administration?
Higgins: What you had in 2008, 2009, and 2010 was a very, very negative fiscal position. As a percentage of GDP, we were almost touching 10% for our deficit. There was a movement to cut spending across the board in defense, which is roughly 50% of discretionary spending. If you take out Social Security, take out Medicare, and take out Medicaid, and you just look at the budget then, 50% of that is defense. The rest is just a lot of other agencies.
We had a decline of the defense budget of about 25% from government fiscal year 2008 to 2015. We think it's bottomed out now, and we think we're heading toward growth. It was a big decline and the industry felt it in its top line. You saw revenue go down. But you didn't see it in its bottom line. The industry kept its margins up, and its return on invested capital was pretty impressive.
Wherry: What's behind the spending reductions?
Higgins: Congress put into effect caps that it could not exceed in 2011--the Budget Control Act. That's why you've seen defense spending decrease up until last year.
You also saw a decrease, though, in defense spending--and it's important to keep this in mind--because the Overseas Contingency Operations account, or OCO. At one point it was running somewhere in the range of $150 billion at its peak. Now it's down around $58 billion. The OCO is related to operations in Iraq and Afghanistan. Now it's decreased, and that's what drove a lot of the decrease in the overall budget.
Wherry: What about markets outside the United States such as Asia, Europe, or the Middle East? In a recent report, you mentioned defense-related spending in Asia could grow 4%. How are defense firms dealing with markets outside the United States?
Higgins: Just to give you a sense of the size. We're talking Northrop Grumman (NOC), Lockheed Martin (LMT), General Dynamics, Raytheon (RTN), and the defense unit of Boeing (BA). They do about $155 billion right now in revenue. About $32 billion of that is international sales.
Now, if you think about the different regions in the world, you touched on the three that really matter outside the United States. Russia and China spend a lot on their militaries, but they're not accessible. So, you' re down to Europe, the Middle East, and Asia--Asia minus China.
In Europe, we think there's a turnaround in budgets happening there, but growth is going to be pretty subdued. Europe also has a fairly robust defense industry, which limits opportunities for U.S. players. But we do see some opportunities, especially because defense spending looks like it's turned around after really suffering from austerity measures.
Then, if you look at the Middle East, we think orders and budgets have peaked there. Spending will keep increasing in the short term, because these orders need to be filled. But I think investors are discounting the impact of lower oil prices. The fiscal position of these countries is really precarious right now.
And then if you turn to Asia, that's where we think the growth is going to be. Asia is not as exposed to the downturn in commodities as other emerging markets. So, from a fiscal position of governments, they are in better shape to spend money on military equipment. And the rise of China is really, really pushing everyone in the region toward modernizing their militaries.
A good example of this is Vietnam. We dropped our arms embargo to Vietnam recently. Not a huge opportunity there. There may be some opportunities in the future. Most of their equipment is Russian. That's where they source from.
Wherry: What type of equipment would a country in Asia be looking to buy?
Higgins: Let's just go region by region. If you think about the Middle East, there's not going to be much demand for subs and ships. But definitely fighter aircraft. There's potential orders coming in from Qatar on the F-15. Ground vehicles--you have the light armored vehicle that General Dynamics just signed a contract for a little while ago with Saudi Arabia. It's a $13 billion contract. Ground vehicles and fighter aircraft are big in the Middle East.
In Europe, it is unmanned systems. The United States has an edge with unmanned systems technology over the Europeans. There's demand for that technology from the Europeans. Potentially, transport aircraft. We've seen delays on their domestically developed transport aircraft, so you could see some aircraft demand out of Europe.
In Asia, there's a lot more demand for naval. Obviously just the geography lends itself to that kind of demand. Fighter aircraft as well. A lot more kind of near-peer, we would say, or conventional weapon systems because of China. Missile defense is strong as well.
Wherry: What about in the United States?
Higgins: In the United States, we are seeing a real shift. It's been going on for a while, so it's nothing new. Defense spending takes a while to change course. In the industry, we like to say it's an aircraft carrier when it turns around. A lot of the focus the past decade was on the Army, just because of the nature of the conflicts we were in. You had programs for ground vehicles. You had a lot of programs that focused on the fighter on the ground.
What we're seeing now is more of an emphasis on things like submarines. We see that in the Ohio replacement program to replace nuclear ballistic missile submarines. There is also the long-range strike bomber that was just awarded to Northrop Grumman. And we see that with ground-based strategic deterrent, which is basically the new nuclear missile that the Department of Defense wants to develop.
What does that mean for the defense contractors that we cover? Well, it's going to favor companies like Northrop Grumman. It's going to favor companies to a certain extent like General Dynamics. It's a mix for them, because they have a lot of ground vehicle work, and in the U.S. ground vehicles are really not a priority at this point. But they do have a big shipbuilding business.
It also going to favor companies like Lockheed Martin. It produces the F-35. That fighter aircraft is designed to go up against countries such as China or Russia.
Wherry: In terms of your coverage list, most stocks are looking fully valued? What's behind the runup in prices?
Higgins: What you saw was a downturn in the defense budget, but you saw operating margins actually expand slightly for the contractors, which was shocking. You saw returns on invested capital stay nice and high at double the cost of capital. They barely came down. And then you saw a large amount of share buybacks and dividends. You're seeing cash returned in terms of share buybacks and dividends running well above 100% of operating cash flow. So, they're spending more cash than they're generating at this point. And investors, frankly, are drunk off all the dividends and share buybacks. Now it is going to be tough for them to expand margins.
Wherry: Given that, you just have one best idea: General Dynamics. What's the thesis there?
Higgins: There are a couple things to think about with General Dynamics. It has the best management money can buy. We're consistently impressed with them. They're not chasing growth. They are laser focused on margins and squeezing efficiency out of the business.
The second thing I would say is their defense businesses. The marine systems business, which does shipbuilding and submarine building, is very well positioned on the Ohio replacement program. That's going to be a very large program, and they've shown that they can manage those programs even if they're complex.
Then, if you look at the combat systems business it has a huge backlog--almost over three times their current sales. They've managed to really capture a lot of business. We think that's going to translate into growth in that segment. We think they're a wide moat. The other defense companies in the space, they're all narrow, except for Lockheed--it's also wide--but the other ones are narrow. And their return on invested capital is top of the class across all the defense names that we look at, so their returns are really solid.
Wherry: If our readers were contemplating an investment in a defense-related firm such as General Dynamics, what are the risks they need to keep in mind before they enter into a position?
Higgins: First, defense budgeting is an annual process, and recently we've seen a lot of continuing resolutions. We may see another one. Basically, what that means is you freeze spending at last year's levels, and there's no new program starts. That's a risk for defense contractors. That really disrupts their business. If it's two or three months, it's OK. If it's nine months or the end of the year, then it's an issue. Another thing I would say is these are complex aircraft and ships that they're building. There is a potential for cost overruns.
This article originally appeared in the August/September 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.
Rob Wherry does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.