President Biden is prioritizing an upgrade and modernization of the military, including ramping up defense capabilities against potential hostilities across the Pacific region, which is broadly supported by both political parties. Large budget deficits don’t seem to be much of a constraint these days. Importantly, global threats are rising, and investors are underestimating the potentially significant secular increase in defense spending if the United States and its allies become involved in a “great powers” conflict.
One optimistic view on spending: during the Vietnam War, defense spending was about 6.8% of GDP, whereas in 2019 it was only 3.3%. If the U.S. increased its spending to only 5% of GDP, and if only 20% of the incremental $340 billion in spending was used to buy hardware (currently about 19% of the defense budget goes into hardware), the incremental $65 billion would equal Lockheed Martin’s total annual revenues.
The defense industry is somewhat unique. It has one very large (sometimes only one) customer – the United States federal government. That single customer has immense negotiating power. Also, complex projects, like building a highly-advanced nuclear submarine, create potentially costly execution risks.
However, defense contractors have valuable strengths, as well. First, their revenues don’t follow the economic cycle, nor does their chief customer have bankruptcy risk. For many contracts, there are few bidders, as the industry has consolidated to only a handful of “primes,” while barriers to entry are almost insurmountably high. Once awarded, a contract can provide stable revenues for potentially decades, with switching costs so high that there is little chance that the contract could be lost. The government helps underwrite research and development costs as well as early production costs, greatly reducing contractors’ risks. When volumes ramp up and efficiencies are developed, the contracts can produce quite respectable profitability, particularly when frequent change orders bring higher incremental margins. Helping boost cash flow, capital spending requirements at defense contractors are generally low.
With the growing pressure to stay ahead/match China’s rapidly-developing capabilities, defense spending could accelerate. Next generation technologies, like remote-controlled and autonomous vehicles (drones), space weapons, hypersonic missiles and new anti-missile defenses, offer the potential for large and enduring contracts. Politics, budgeting and fiscal realities could dampen the appetite for these initiatives, but the secular trend is toward higher defense spending.
Nearly all of the prime contractors are out of favor, despite some recent upward moves. We have listed six defense companies below that look like turnaround stock candidates, including a few specialized and smaller companies.
6 Out-of-Favor Defense Stocks
General Dynamics (GD) – General Dynamics is one of the primes, with a focus on naval combat vessels, land-based combat vehicles and ordinance, and a range of communications and other systems. The company is the prime contractor for the Navy’s Columbia-class nuclear submarine, which will continue into the 2040s. Its M1 Abrams tank contract and the Bradley Fighting Vehicles likely have many more years ahead.
A key segment, and a driver of its shares, is its valuable Gulfstream business jet franchise (which also produces jets for the military) that dominates its industry with a 50% market share. Gulfstream should rebound from its pandemic-related weakness and its introduction of the new G700 next year. Lucrative aftermarket revenues are as much as 25% of this segment’s sales. General Dynamics has a reasonable balance sheet, pays an attractive (and recently raised) dividend and generates strong free cash flow.
Huntington Ingalls (HII) – There is a lot to not like about Huntington Ingalls, America’s largest shipbuilding company. The company generates low operating margins of about 9% (compared to low teens for other primes), it holds the weak end of the nuclear submarine duopoly and could see its Virginia-class submarine contract trimmed, and the long-term outlook for large nuclear-powered aircraft carriers (which provide about 33% of total revenues) is being doubted due to their vulnerability to modern missiles.
But, there is also a lot to like. Nuclear submarines are arguably the Navy’s highest-priority weapon category. Its monopoly on large-scale nuclear aircraft carriers will likely last for at least another decade and provide servicing and maintenance revenues for even longer. If the Navy shifts to smaller carriers, Huntington could be in a strong position to win those contracts. A recent acquisition positions Huntington as a leader in uncrewed undersea vehicles, a category that may have a major role in the future of naval warfare.
It is also the sole builder of two amphibious assault ships with encouraging long-term demand. Investors would cheer the divestiture of its low-margin IT services business as it would improve both the optics and reality of Huntington’s strategic focus and margin structure. Free cash flow will likely increase toward 100% of net income as its capital spending programs are winding down. The balance sheet is solid, with its modest debt partly offset by $407 million in cash.
Kaman Corporation (KAMN) – Founded in 1945 by aviation pioneer Charles Kaman, this company produces highly-engineered components, specialty fuzes (mechanical fuses) for missiles, and various assemblies. About 55% of its revenues are generated from the defense sector, with another 28% from commercial aviation. Its workhorse helicopter, the K-Max, offers the potential to enter the unmanned next-generation airlift segment. The shares remain at their 2017 level, largely due to weak commercial aviation volumes. Partly in response, Kaman is undergoing a cost-cutting program to boost its margins and free cash flow. Kaman has an active acquisition and divestiture program – one possible but perhaps unlikely catalyst would be the divestiture of its unrelated medical/industrial operations which produce almost 17% of total sales. We see mostly continuity from the planned CEO succession that occurred last September. Kaman’s sturdy balance sheet holds $120 million in cash and only $199 million in debt.
Lockheed Martin (LMT) – Lockheed produces a wide range of weapons systems. Its marquee contract is for the F-35 Joint Strike Fighter (about 30% of revenues), which likely has over 30 years of remaining life. It is also well-positioned in hypersonic missiles and missile defense systems, in vertical lift through its Sikorsky helicopter unit, and in non-nuclear-powered ships through a joint venture with FMM. Its pending $4.4 billion acquisition of Aerojet Rocketdyne, a specialist in rocket propulsion, could significantly increase its strengths in missiles and rockets, although this deal may run into antitrust issues.
The company has headwinds, as well. It is a partner with Boeing in the United Launch Alliance, which may see competition from SpaceX and Blue Origin. Its highly regarded former CEO, Marilyn Hewson, was replaced by James Taiclet, the former head of wireless tower giant American Tower early last year. Taiclet is highly capable but investors wonder how well his skill set will transfer to the complex defense industry. The company’s net debt is about 1x EBITDA and the shares pay an appealing 2.7% dividend.
PAE, Inc. (PAE) – With revenues of $3.1 billion, PAE is a 20,000-employee firm that provides a wide range of specialized field services to the U.S. State and Defense departments including infrastructure, training, intelligence, and other mission support services. One of its long-standing contracts (since the 1970s) is to provide high-profile support for large U.S. embassies around the world. Founded in 1955 as Pacific Architects and Engineers, the company was one of the largest providers of contract services during the Vietnam War. It was acquired by Lockheed Martin in 2006, then by a series of private equity firms and the founder’s family, who helped the firm diversify its client base, improve its margin structure and upgrade its service offerings. In February 2020 PAE went public via a merger with a specialty purpose acquisition company (SPAC).
Earlier this month, the company’s CEO departed abruptly, which creates some uncertainty. But, as the company is undertaking a search, it provides the opportunity for an outsider to bring a fresh perspective. PAE’s balance sheet carries reasonable debt, and it looks well-positioned for another year of sizeable and improving free cash flow to help pay down that debt. While its ownership and leadership turnover create risks, its low valuation and new owners create interesting upside potential. Investors will want to be aware of a share base overhang from private equity and SPAC owners exiting their positions and from some dilution from public and private warrants and earn-outs.
Viasat (VSAT) – While only partly a defense contractor, Viasat owns and operates satellite-based telecom and Internet connections for locations that have no conventional links, including commercial jets, military battlefields, remote homes and ocean vessels. Its encryption systems have earned considerable acclaim for their security, helping build credibility for its military-related operations. The company recently won a contract from Delta Airlines to provide in-flight Wi-Fi service, with Delta paying for the build-out.
While Viasat competes directly with Elon Musk’s Starlink and other satellite networks, it continues to hold its market share as demand remains robust, suggesting that the market is fairly large for this service. Free cash flow will be limited as the company is building out its Viasat-3 constellation over the next few years. Recently, the founder/CEO passed the baton to his long-time COO but we expect few changes. Viasat’s balance sheet carries reasonable debt which will likely be reduced in coming years.
What do you think of the defense sector right now? Do you own any of the above stocks in your portfolio already?