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Getting Defensive in Defense Stocks

(Guest Commentary by Rick Konrad – December 3, 2009)

Dear Subscribers and Readers,

I hope all of our American subscribers had an enjoyable Thanksgiving!  For those who had want learn more about picking stocks, evaluating companies, industry trends, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a guest commentary.  Rick has been a regular guest commentator for a few years now (every third Wednesday of the month) but is now offering his insights every first Wednesday of the month as well!  We highly appreciate your investment insights and general wisdom, Rick!

In this commentary, Rick will discuss the defense industry in light of the proposed military buildup in Afghanistan.  While Rick realizes that this may be too obvious to most investors, he also asserts that many investors have structurally underweight defense stocks.  As a result, defense stocks now deserve a review, especially Raytheon.  This is again a must-read.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator on MarketThoughts.com (please see "The Great Depression in Listings" for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog.  You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been involved with grading CFA examinations.

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


Experience is a hard teacher because she gives the test first and the lesson afterward.

Last night, to no one's surprise, we received the news that the US is sending 30,000 more troops to Afghanistan by the summer of 2010. Earlier today, we observed the testimony of the US  Defense Secretary Robert Gates telling the Senate that  failure of the  international  effort in Afghanistan would mean a Taliban "takeover" of much of the country. The chief of NATO followed along this morning, announcing  the organization's support for President Obama's escalation, and pledging 5,000 additional troops.

Whatever your reaction to this strategy from a political or moral standpoint, it is an important reminder of ongoing efforts by the free world to counter terrorism and following the Thanksgiving holiday, how grateful we should be for the young men and women who face danger every day on our behalf.

Terrorism, though hardly new, is an omnipresent threat in our world. In 1982,  John Naisbett wrote Megatrends, a book that anticipated many key social and business factors such as globalization, empowerment and the rise of information technology. As the Berlin Wall collapsed in 1989, one of the new megatrends was the breakout of peace and freedom. Though most of us take our freedom for granted and conversely, find defense spending excessive, if not wasteful, perhaps one of the megatrends we need to recognize in our investment portfolios is the ongoing need for defense and security.

Sometimes what appears too obvious is an impediment to our executing an investment strategy. This macro trend seems almost too obvious, almost too recognized. Yet, as I look at various institutional accounts and especially retail accounts, few have much representation in the sector. When most corporations find revenue growth challenging, this sector continues to receive a fairly steady growth of contracts and revenues. Despite a whirlwind of fiscal woes and needs, I cannot imagine a political scenario that would allow the country to dismiss its security.

Particularly in a world where old military infrastructure such as fighter planes and aircraft carriers seems antiquated or ill-suited relative to today's battlegrounds, there is a technological impetus for new weaponry and intelligence.

In short, much like the 80's and 90's where tobacco stocks tended to be the most reliable and defensive sector that most portfolios contained, I wonder if defense stocks become the new defensive sector.

Macro view of the Defense Industry-U.S. defense spending has been on an extended cycle (some 9 years of up-cycle) which has translated into profitability that has exceeded most analyst expectations. Many observers of the industry were calling "the end of the cycle" back in 2003-2005. Yet, spending picked up, even despite a newly elected Democratic majority in both houses of Congress-remarkable in that Bush budgets actually were augmented by politicians who had campaigned against previous military budget hikes. According to Wikipedia, “For the 2009 fiscal year, the base budget of the Department of Defense rose to $518.3 billion. Adding emergency discretionary spending, supplemental spending, and stimulus spending brings the sum to $651.2 billion. Defense-related expenditures outside of the Department of Defense constitute between $274 billion and $493 billion in additional spending, bringing the total for defense spending to between $925 billion and $1.14 trillion in 2009.” These incremental amounts above the DoD requirements include spending for Homeland security and FBI counter-terrorism, programs which regrettably remain essentially non-cancellable. Even when DoD spending is seemingly being trimmed as Secretary of Defense Robert Gates proposed earlier this year, the proportion of defense relative to total GDP is being addressed, rather than the amount of spending. Proposed spending cuts were primarily dedicated to large visible programs such as the F-22 or exotic Navy stealth destroyers. As Gates indicated earlier this year, changes were driven not by budget restraints or by directives from outside the Defense Department but, rather, by his own sense of a need to "rebalance" the Pentagon's programs—"to institutionalize and enhance our capabilities to fight the wars we are in today and the scenarios we are most likely to face in the years ahead." On a cynical note, it is important to realize that spending on wars in Afghanistan and Iraq is derived through supplemental appropriations and not through the regular budget, understating our illustration of the scale of defense spending, and cynically, most congressional oversight mechanisms opaque. Here is a look at the latest Congressional Budget Office view of government spending:

Outlays Through September (Billions of dollars)

Hence, it is my opinion that relative to most other industries, the defense industry, despite the rhetoric and political posturing, and because of the long-term nature of many government contracts, remains one of the more reliable engines of revenue growth.

Raytheon (RTN)

Market Cap $19,785 billion
Long term debt $2.397 billion
Cash $2.442 billion
Enterprise Value $19.740 billion
TTM Free Cash Flow: $1.879 billion for FCF yield (based on Enterprise Value) of 9.5%

In my view, RTN should sell at a superior valuation to its peers due to:

  • Its strong position in unconventional warfare, particularly in intelligence technology.
  • Its zero exposure to commercial businesses.
  • Its diverse contract base with over 15,000 contracts. No single contract exceeds 5% of revenues.
  • Its significant international revenues relative to its peers. RTN's international sales currently represent about 20% of sales as compared to 13% at Lockheed Martin, the second most international rival, and 10% and 9% respectively for General Dynamics and Northrop.

From a valuation standpoint, using IBES consensus numbers, RTN trades at under 10.4 times the consensus 2010 estimate of $4.97.  Analysts have consistently under-estimated RTN's earnings this years; it is the only major defense contractor where the standardized unexpected earnings SUE) has exceeded two standard deviations in every quarter of 2009. RTN has a better balance sheet than its peers, in fact, the company has cash net of debt. At current prices, RTN yields 2.4% with a current payout ratio of 25.5%, the lowest payout ratio of its major peers.

 Five year revenue growth has been 5.1% but largely due to operating leverage and expense control, earnings have compounded over that period at 25.1%. Dividend growth has lagged at 9.8% however; there has been significant share repurchase, recently at a $300 million per quarter clip.

Given its high quality balance sheet, diversified contract base, superior growth characteristics and attractive valuation relative to its peers and to the S&P 500 index, we believe that RTN is undervalued.

Recent Raytheon News- http://tinyurl.com/yfkcxyb

Disclaimer: I. my family and some clients currently own a position in Raytheon. Some clients own a current position in General Dynamics.

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