By Ben Strubel of Strubel Investment Management, LLC
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Many value investors have given up on their strategy over the last 15 years amid concerns that value investing no longer worked. However, some made small adjustments to their strategy but remained value investors to the core. Now all of the value investors who held fast to their investment philosophy are being rewarded as value Read More
The Federal Government is broke. They depend on borrowing from China and other investors to pay their bills. At least that is what we are constantly told. Both parties are proposing massive Federal budget cuts. So why would we be dumb enough to buy a defense contractor, let alone the defense contractor responsible for biggest contract the DoD has undertaken, the JSF program, that has been plagued by cost overruns.
Looking beneath the headlines, many of these risks aren’t what they first appear to be. Let’s take a look at each issue individually.
Federal Government Spending
Despite what the media and Congress might have you believe the Federal government is not broke and it most certainly does not borrow money from anyone let alone China. The US Federal government (I’m combining the Federal Government, Federal Reserve, and Treasury Dept. for ease of explanation purposes) is monetarily sovereign, that is it operates a non convertible, floating exchange rate, sole issuer currency system. The one and only entity that can issue dollars is the US Federal government. Comparisons of the Federal government to states, businesses, or households, or non-monetarily sovereign currency using nations such as Greece or Italy are flawed.
The Federal government spends money by simply marking accounts in computers up or down. It then issues T-securities to “mop up” the excess reserves in the banking system that any spending in excess of tax receipts created. Taxes do not fund the Federal government’s spending. The budget deficit is simply the amount by which the government has provided net assets to the private sector in excess of tax receipts. The national debt is therefore nothing more than an accounting identity equal to the net private sector savings. It is not some mythical burden our children need to payoff.
Federal government spending is then only constrained by two things. The first is inflation, which with unemployment over 9% is not a threat. The second is the political will to spend, which right now is the biggest sticking point. The DoD has already published its plans for reducing expenditures which, to the extent they affect defense contractors, have already been priced in to the stock. Additionally, Washington seems to have no appetite for further DoD budget reductions. Both the President and Congress have been zeroing in on Medicare, Medicaid, and Social Security for cost savings.
I realize the information about how the monetary system works is new to most people. For more information on how the Federal government spends and how the monetary system works I recommend the following links.
Articles by Warren Mosler (more in depth)
Articles by John T. Harvey on Forbes (generally shorter and easier to read)
We Spend as Much on Defense as the Next X Number of Countries Combined
In 2010 U.S. military expenditures (including the wars in Iraq and Afghanistan) were approximately $687B. Critics frequently then show how this figure is larger than the next X number of countries combined. Well, of course it is. The US military affectively subsidizes security for the Western world.
From the 2010 Quadrennial Defense Review:
“Since the United States assumed the role of a leading security provider after the end of World
War II, DoD has worked actively to build the defense capacity of allied and partner states. Doing
so has also given the U.S. Armed Forces opportunities to train with and learn from their
counterparts. These efforts further the U.S. objective of securing a peaceful and cooperative
international order. Security cooperation activities include bilateral and multilateral training and
exercises, foreign military sales (FMS) and financing (FMF), officer exchange programs,
educational opportunities at professional military schools, technical exchanges, and efforts to
assist foreign security forces in building competency and capacity. In today’s complex and
interdependent security environment, these dimensions of the U.S. defense strategy have never been more important. U.S. forces, therefore, will continue to treat the building of partners’ security capacity as an increasingly important mission.” [emphasis mine]
In plain English, “basically everyone we work with is incompetent but us.”
Additionally NATO action in Libya shows just how dependent NATO nations are on US support. It was only the US that had the capability to neutralize Libya’s integrated air defense network (assuming it was functional). The NATO coalition was also dependent on US intelligence gathering and targeting specialists, and as the war dragged on eventually dependent on US munitions stocks. (Source: Departing Secretary of Defense Gates’ comments: http://articles.latimes.com/2011/jun/10/world/la-fgw-gates-brussels-20110611)
Finally while US military expenditures are high in absolute dollars they are at low levels when put in a proper context at only 4.7% of GDP. At the height of the Vietnam War military spending reached 8% of GDP. Backing out the wars and other overseas operations the base DoD Budget was $527.9B or 3.6% of GDP.
Military Budget Overview
It is well known that the DoD is reducing its budget. What isn’t as well known is what portions of the budget are being reduced and how the cost savings are being deployed. In short the DoD is reducing manpower and restructuring to save money to invest in new weapons systems and capabilities.
The DoD base budget is broken down in to multiple categories. The categories most important to defense contractors make up what is called the Investment Account which includes Procurement and Research, Design, Testing, and Evaluation (RDT&E).
The DoD budget request for fiscal 2012 is $553B.
The proposed budget for FY2013 through FY2016 shows slowing top line growth.
(Source: DoD FY2012 Budget Request Overview http://comptroller.defense.gov/defbudget/fy2012/FY2012_Budget_Request_Overview_Book.pdf)
In order to meet these proposed budgets the DoD has undertaken a $178B cost savings program composed of $78B in reductions from the DoD and $100B of reduction from the services (Army, Navy, and Air force). The $100B the services save will be reinvested.
The DoD’s $78B in savings comes primarily from:
- DoD staff efficiencies: $54B
- Restructuring and re-pricing the JSF program: $4B
- Adjustments in economics assumptions: $14B
- Reducing ground forces in 2015-2016: $6B
The $100B reduction for the services is shown on the following table.
As we can see the items receiving the smallest budget cuts are the weapons system programs. So what is the DoD going to do with the $100B in projected savings?
$28B will be spent on “must pay” bills such as staff expenses, training, and maintenance. $70B will be invested across the three major services mainly in acquiring new weapons systems or modernizing existing weapons systems.
- Army: Modernize the M1 Abrams family of tanks, Bradley fighting vehicles, and Strykers; and expand ISR capabilities.
- Navy: Refurbish Marine equipment. Purchase more F-18 and pay for a service life extension program. Finally procure six additional ships. One LCS, one DDG-51, and four support ships.
- Air force: F-15 modernization program, more UAVs, and start the next generation bomber development program.
Additionally, defense contractors haven taken to using the tactic of scattering the work of large profitable contracts over politically important Congressional districts. No Senator or Representative wants to be the man or woman who cast a vote that cost people in their district jobs. Once programs are deeply ensconced it is very tough to kill them. Exhibit A for this would be the multi-year squabble over when to shutdown the F-22A production line that only ended with the threat of a presidential veto.
In the end, despite what the headlines say, the defense budget is projected to grow by low single digits with an emphasis on modernizing the armed forces by continuing to purchase new systems or upgrade or refurbish existing platforms. A majority of the areas that most big name defense contractors serve will still be a (slowly) growing sector.
Military Procurement Process
One of the most frequent criticisms leveled at defense contractors and weapons system procurement is that projects almost always end up delayed and over budget. Frequently it is the defense contractors that are cast as the screw-ups costing average Joe taxpayer more money. In many cases the blame lies with the military’s policies and not the defense contractor. First, the initial cost estimates are almost always fantasy land numbers that it is widely known have no hope of being met. Also, the military has a bad habit of changing the parameters of a project multiple times throughout its lifecycle. Add to that the fact that many projects entail the development of new or cutting edge technology and the delays and cost overruns are no surprise. In fact in the latest budget request the DoD says just that:
“Too often, DoD establishes unrealistic requirements for its future systems that are at the far limit of the technological boundaries. Sometimes these can lead to breakthrough developments that can revolutionize warfare. But far more often, the result is disappointing initial performance followed by cost and schedule overruns to correct those performance failures.
The Department needs to add critical skills to its acquisition workforce. Over the last 10 years, defense spending on contracts for weapons and other systems nearly tripled – while the DoD acquisition workforce fell by about 10 percent. More important, the Department lacks sufficient numbers of technically trained personnel to conduct effective oversight. The Department needs additional contracting officers, cost estimators, systems engineers and acquisition managers.
The Department must no longer rely on overly optimistic cost estimates. To produce weapon systems efficiently, it is critical to have budget stability. But it is impossible to attain that stability
in our modernization budgets if the cost of our weapons systems is underestimated from the start.”
The main thrust of the DoD to rectify the problems will be changes within the DoD itself. The DoD is not hanging defense contractors out to dry and simply shifting the blame on them. While there will be some changes to how contracts are written in the future a majority of the changes are within the DoD and apply to how they will conduct business.
Given the nature of the procurement process and the fact that the JSF is one of the most technologically challenging programs currently in development it should be no surprise that the System Development & Demonstration (SDD) phase of the program is over budget. Additional details regarding the JSF program are discussed in the “Lockheed Martin Overview: Aeronautics” section.
Lockheed Martin Overview
Lockheed Martin (LMT) is the world’s largest pure play defense contractors. In 2010 Lockheed derived 60% of its revenue from the DoD, 24% from other domestic governmental agencies, 15% from international customers, and 1% from commercial clients.
The company is organized in to four divisions Aeronautics, Electronic Systems, Information Systems & Global Solutions (IS&GS), and Space Systems.
Lockheed’s Aeronautics division is its largest and accounted for $13.2B (or 29%) of revenue in 2010. Aeronautics derives 81% of its revenue from domestic customers and 19% from international customers.
Aeronautics business lines
|Business Line||2010 Aeronautics Revenue|
The US air force has a big problem. Its main frontline combat fighter aircraft are old (with the notable exception of the F-22A). Not just a little old, but very old. According the air force in 2008 the average age of its aircraft was 24 years, the oldest in its 61 year history.
The current Air Force inventory of frontline fighter aircraft consists of 267 F-15C/D models, 223 F-15E models, 1,262 F-16C/D models, and 187 F-22A models. The F-15C/D air superiority models are a circa 1972 design built between 1979 and 1985 with various upgrades along the way. The F-15E long range interdiction model is a circa 1979 design that was built between 1985 and 2001 with various upgrades along the way. The air force’s most numerous frontline fighter is the F-16C/D models that are a circa 1974 design built starting in 1984 with various upgrades along the way. The F-15 and F-16 models are considered fourth generation fighters. The only modern fifth generation fighter in service is the F-22A Raptor a 1997 design whose production line is set to close in 2012 after producing 187 aircraft. Lockheed Martin is the prime contractor for the F-16 and F-22 while Boeing is the prime contractor for the F-15.
The air force is essentially left with two options either procure more newer aircraft per year or refurbish existing inventory to extend their life and upgrade their capabilities. Currently the plan for frontline fighter aircraft is to replace aging aircraft with the new Lockheed Martin product the F-35 Lightning II Joint Strike Fighter (JSF).
From the JSF Program website:
“For the U.S. Navy, the JSF will be used in a “first day” of war, as a survivable strike fighter aircraft to complement F/A-18E/F. The U.S. Air Force will employ it as a multirole aircraft, primary-air-to-ground, which will replace the F-16 and A-10 and to complement the F-22. The Marine Corps will use the Short Takeoff and Vertical Landing (STOVL) variant of the aircraft to replace the AV-8B and F/A-18A/C/D.”
We believe that the JSF program is the most attractive asset in LMT’s portfolio. With the scheduled closure of the F-22A production line the JSF is the air force’s only option for procuring a frontline fifth generation stealth fighter. With the emerging threat of the new Chinese J-20 stealth fighter we believe it is highly unlikely significant cuts will be made to the JSF program. The air force essentially has no choice but to go forward. It would take decades and untold billions to start a new frontline fighter development program and bring production up to a reasonable level. It also can’t just “make do” with older inventory as those will need extensive rebuilding and modernization to extend their service lives and make them capable on the next generation battlefield. In short the air force is stuck with the JSF.
Finally most of the JSF delays and cost overruns have been due to the short take-off and vertical landing (STOVL) variant. The conventional take off and landing and the carrier version which make up 85% of the planned production run have been certified by the DoD in 2010 as proceeding satisfactorily. While Lockheed’s margin on the SDD phase of the program may come under pressure due to cost overruns once production begins to ramp up margins will increase. Indeed, the same thing happened with the F-16 program where each successive production lot saw Lockheed increase margins. Also, despite the problems with the STOVL variant the Marine Corp has called that version essential and that they have no plan B.
Additionally with the F-22A banned from export and the production line shutting down the JSF program will be the only fifth generation fighter being offered to international customers. Israel is expected to be the first international customer to receive deliveries. Other international customers will be the United Kingdom, Italy, the Netherlands, Canada, Turkey, Australia, Norway, and Denmark. Altogether 3,100 F-35s are expected to be procured by 2035.
The F-35 Lighting II JSF made up 12% of Lockheed’s sales in 2010.
Other major Aeronautics products and programs include the C-130J and legacy C-130 support, C-5A/B/C support, C-5M modernization, and Advanced Development Programs (ADP) which includes the infamous Lockheed Martin Skunk Works.
Backlog at Aeronautics is expected to be stable to up.
Electronic Systems is Lockheed’s largest division and accounted for $14.4B (31%) of net sales in 2010.
|Business Line||2010 Electronic Systems Revenue|
|Mission Systems & Sensors||44%|
|Missiles and Fire Control||36%|
|Global Training & Logistics||20%|
Major programs include sea-based elements o the US missile defense system, the Aegis Weapons System (found on every DDG-51 destroyer), the Terminal High Altitude Area Defense (THAAD) missile system and PAC-3 missile, and the Freedom Class (aka the normal looking monohull one) Littoral Combat Ship (LCS).
All major programs are important parts of the DoD’s budget going forward. The Aegis Weapons System is an absolutely critical component of every navy destroyer being built and currently in service. More information on Aegis can be found here. The THAAD missile system is the only missile defense system that can protect against atmospheric and exo-atmospheric threats. The program has also garnered a high level of international interest. The LCS is the Navy’s new smaller warship designed to deal with coastal threats. The ship may generate international interest but it would be up against stiff competition.
Backlog at Electronic Systems is expected to be stable to up.
Information Systems & Global Solutions
IS&GS accounted for $9.9B (22%) of net sales in 2010.
|Business Line||2010 IS&GS Revenue|
IS&GS primarily provides communication, automation, and data integration services. Major civil programs include the En Route Automization Modernization contract with the FAA the Hanford Mission Support contract for the DEA. The core programs for the intelligence business line are, as one might guess, classified.
Backlog at IS&GS is down and falling.
Accounting for only $8.2B (18%) in revenue for 2010, Space Systems is Lockheed’s smallest division.
|Business Line||2010 Space Systems|
|Strategic & Defensive Missiles||16%|
Major programs include the Space Based Infrared System (SBIRS), Mobile User Objective System (MUOS), Advanced Extremely High Frequency System (AEHF), GPS III system, Geostationary Operational Environmental Satellite R-Series (GOES-R), the Trident II D5 Fleet Ballistic Missile, Orion CEV and Space Shuttle processing, and several classified systems.
Backlog at Space Systems is expected to be stable.
Major Programs Overview
(Source: Lockheed Martin 2011Q1 Earnings Presentation)
The defense industry is characterized by wide economic moats for those contractors working on major programs. The DoD has also employed a policy of making sure all the major players stay in business by spreading contracts around. For example although Lockheed is the lead contractor on the JSF many other contractors play a role. Also the Navy decided to build both classes of the new LCS ship, one a Lockheed design and another a design lead by General Dynamics (GD).
Major domestic competitors include Northrop Grumman and Boeing in Aeronautics and Raytheon in Electronic Systems. IS&GS is the most competitive field with just about every major contractor having a similar division and plenty of smaller niche contractors compete in this area as well. Boeing is the main competitor for Space Systems.
Lockheed Martin is currently trading at historically low valuations. Lockheed currently trades at a P/E of 10, a Price/Sales ratio of .5 and a Price/Cash flow ratio of 7. Over the past 15 years Lockheed has traded at an average P/E of 17 and median P/E of 16. Over the last 10 years the average P/S and average P/CF have been .8 and 10 respectively.
Based on analyst estimates and our own estimates we put together the following table that shows the value of Lockheed’s equity under several different scenarios. The notes following the table detail the reasoning for our assumptions.
Notes to the Valuation:
1) FY2012 revenue for the base case is slightly below analyst estimates of $47.62 to reflect a more sluggish state and local government spending environment than expected (affects IS&GS).
2) Aeronautics EBIT margins median 11.7% over the past 6 years. We slightly lowered margin to account for near term cost pressures with JSF.
3) Electronic Systems EBIT margins median 12.1% over past 6 years.
4) IS&GS EBIT margins median 9.1% over past 6 years.
5) Space Systems EBIT margins median 10.8% over past 6 years.
6) LMT records pension liabilities using FAS but is reimbursed for pension costs under CAS. Ultimately all pension costs related to domestic government work are fully reimbursable.
Lockheed Martin has perhaps the best portfolio of core programs including the JSF crown jewel. Despite the headlines the defense spending environment is still attractive as the DoD is intent on modernizing its forces.
Defense contractors and Lockheed in particular offer a hedge against continued consumer weakness. If Washington goes through with cutting spending on social programs and raising taxes it will further slow already anemic economic growth. Because Lockheed is largely uncoupled from the consumer environment we believe it offers a good hedge against this outcome.
Finally, should we be wrong and the economy strengthens (and thus tax receipts rise) Lockheed should benefit by DoD environment with less budget pressure.
Either way, the country’s military needs new weapons systems and Lockheed is one of the companies leading the way to build them.
Disclosure: Long LMT. Considering purchase of GD, HRS, and/or NOC in coming months.