Big Defense Earnings

This week's episode of Industry Focus: Energy is all about big defense -- the companies behind things like missiles, ships, and intelligence services. Host Michael Douglass and Motley Fool contributor Lou Whiteman run through the latest earnings reports from Lockheed (LMT 0.01%), Raytheon (RTN), General Dynamics (GD 0.28%), and Northrop Grumman (NOC 0.10%).

Find out the most important earnings numbers, how they compare to each other, how they're setting themselves up for the future, and more. Also, the hosts explain how the industry works, some general trends and risks to watch out for, how these companies are setting themselves apart from each other, and which looks like the best investment going forward.

A full transcript follows the video.

This video was recorded on Aug. 16, 2018.

Michael Douglass: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Thursday, August 16th, and we're talking about defense major earnings. I'm your host, Michael Douglass. I'm joined by Lou Whiteman. Lou, it's your second time on the show. This is my third of fourth Energy show. That means we're about the same level of experience here, right?

Lou Whiteman: Eh, OK. [laughs] 

Douglass: [laughs] Lou, it's good to have you here! What I'm thinking for today's conversation, it'll sound a little bit similar to our last two. Last week, we did midstreamers; the week before that, we did oil majors. We'll just talk a little bit specifically about each company. That's Lockheed, Raytheon, General Dynamics, and Northrop Grumman. Then, we'll sum up with some general thoughts, and I'll ask Lou to pick his favorite of the companies, which I warned him about beforehand! He's prepared. He's nodding, I want you to know. 

Let's hop right in, let's talk about Lockheed first. Listeners, Lockheed's ticker is LMT. Generally speaking, I'd say a pretty good second quarter report. Revenue was up 6% year over year, earnings per share up 23%. Folks who listened to the Financials show back when I was hosting that, less than a month ago, will remember that we talked a lot about the tax law's impact on earnings. Certainly, that has been the case here. Income tax rate was down almost 11% to 18%. That's a huge driver of underlying profitability, and something we'll be talking about with each of these companies a little bit. A lot of other insights to have here, Lou. What do you think?

Whiteman: This was the quarter. The more I looked at this quarter, the more I liked it. Yes, tax helped, but Lockheed is by far the biggest of these companies. This is a bad problem to have, they are very dependent on the F-35. It's more than a third of their revenue. That's the Joint Strike Fighter. It's only ramping up now. 

What was really nice about this quarter was, it really makes the case that there's more to Lockheed than this plane. Hypersonics, these faster than the speed of the sound missiles; Sikorsky, their helicopter unit, is looking to ramp up. Most importantly, CFO Bruce Tanner on the conference call basically said, "We're winning more business than we budgeted for." They budgeted to win maybe 65% of the bids they put in. They're outperforming in a lot of different areas, and that's great news for the holders of the stock. This was a really impressive quarter for Lockheed, in terms of setting them up for what comes next.

Douglass: Aeronautics is their largest unit, it's 40% of the total business, up 8% year over year. A lot of that is F-35 ramp-up. Then, Missile and Fire Control, you talked about missiles, up 17% year over year. That's the kind of numbers that make a growth investor like me give a company a second look.

Whiteman: This is a trend, too. We're going to talk about this with a few of the companies. The Pentagon has priorities. One of them is missile, and almost more important than missile, missile defense. Look no further than what's going on in North Korea. That's a Lockheed system that they're installing in Guam, the THAAD system. Lockheed also makes the actual missile on the Patriot missile. We'll talk about that with another company, too. 

This is just ramping up now. This is going to be a trend into the early part of the next decade, where we are going to see demand not just from the U.S. but from U.S. allies, as well. Lockheed has estimated maybe $7 billion in extra potential funding from increased budgets over the coming years. A lot of that is missiles. Based on this quarter, you have to like their chances of winning a lot of that business.

Douglass: Absolutely. Perhaps unsurprisingly, when you post good numbers and have good underlying drivers, they also raised guidance a little. That's always preferable to the alternative.

Whiteman: If anything, I believe the revenue growth guidance is 5% or so. I wouldn't be surprised, looking into 2019 and even into 2020, I would bet that's on the low side. You hate to go too high on an industrial, but I think that 5% growth in revenue, that's very beatable.

Douglass: Good stuff. Let's head on over to Raytheon. A fairly similar story. Revenue was up 5.5% year over year. Earnings per share from continuing operations up 47%. Again, a sizable benefit from tax reform. Plus, they're planning a sizable discretionary pension contribution, which comes with some tax benefits for them. That's going to juice up earnings for them for a bit. Really, the standout number for me was, bookings were up 33% year over year. That's just wild.

Whiteman: That's wonderful. That's space and, again, missiles. We're going to talk about missiles a lot with Raytheon. This is a trend that's helping the industry, we've gone from sequestration, where there wasn't a lot of funding, to, now the Pentagon is playing catch-up with the 2018 budget that was passed earlier this year. A lot of that money is flowing into areas where Raytheon specializes. Bookings, again, this quarter was decent, but looking ahead, there's a lot to be excited about.

Douglass: Folks who listened to the general defense episode with Lou and Sarah a month ago will hear some of the same things they talked about there. It's inevitable when we're covering the same businesses. It's interesting, Raytheon is nearly evenly divided across its four major business lines by revenue. Unlike Lockheed, which is really concentrated in aeronautics, Raytheon has fairly similar revenue contributions from each. 

Of course, defense systems, that's missiles, 17% operating margin last quarter. Biggest revenue contribution was Patriot missile contract with Romania, highlighting that trend you were talking about there, Lou.

Whiteman: Raytheon is interesting. Of the four companies we're going to talk about, they are the specialists. They don't make the war ships, they don't make the tanks, they don't make the F-35 fighter. They do missiles, they do missile defense, and they do a lot of electronics and sensors that end up on these programs. They are really in the sweet spot for what the Pentagon is focused on right now. Which is helping. 

Their book to bill for the quarter, which is, how much is coming in vs. going out, was 1.3X. That's about the best I saw. It really speaks well for the future. They hiked bookings by about $1 billion. If anything, that might feel conservative, especially with some of these -- you mentioned Romania -- international orders. Raytheon, more than any company, is very good at foreign sales, partially because of what they sell. There's a lot of reason for optimism, again, going into 2019, with this company.

Douglass: Raytheon, also pretty good at intelligence work. Of course, that's basically all classified, so we don't know much about it, except that Raytheon bumped revenue by 8%. And, well, that's about it. It's hard to get a lot of insight there.

Whiteman: I would wager some of that is platform work, too. Some of that is the sensors and electronics and some of these other things. It isn't all just spying. But, yeah, that's a fun, or not so fun, thing about this industry. We'll get to it with another company in a second, too. It's hard to get clarity sometimes, because a lot of this stuff, the customer doesn't want them to talk about.

Douglass: Understandably. Let's turn to General Dynamics, ticker GD. One of the big stats that you immediately notice with General Dynamics is, everybody else's revenue was up 5% or 6%. General Dynamics' revenue was up 20%. Of course, all you have to do is peel back one layer to see that was the CSRA buyout. Their organic defense business revenue is up about 7%. That's what happens when you net out the benefit of a fairly sizable purchase.

Whiteman: There wasn't the wow that there was for other companies, but there was a lot to look at here. You mentioned the CSRA deal. That's a government IT firm. The interesting thing there is, General Dynamics is basically doubling the GDIT, they call it, their IT business, at a time when Lockheed and some of the others have divested it completely. They are betting the other way. 

They are now probably the second largest by revenue. There's a specialist, Leidos Holdings, that is bigger. This is an area of the budget that was neglected during the budget wars. The Pentagon kept buying war planes, but they didn't necessarily upgrade their IT systems. Federal discretionary spending is up 6%. 

Who knows, long-term. I like the move, but the move is questionable. We'll see what we think about it 10 years down. In the next year or so, this is going to be a driver. All of these government IT firms should be strong for the next 12 to 18 months, with the awards they're getting. GDIT is going to get a lot of that business, because this is a business where scale matters, and thanks to that deal, they have scale. In the short-term, it's going to help results.

Douglass: As with all things here at The Fool, we end up saying, "Five or 10 years from now, we'll really know. But for the moment, here's what it looks like things are doing."

Whiteman: It's interesting, because they're going in a different direction. These companies are a lot alike. They serve one customer, so they have to be. It's interesting, this is a real case where one company is going a different direction than their peers. A lot of smart people disagree on this. It's fun to watch it play out.

Douglass: Speaking of going different directions, let's also talk about Gulfstream a little bit. That has been one of the big things holding General Dynamics back.

Whiteman: Yes. Gulfstream is another area where General Dynamics is different from its peers. They have a large commercial business, and that's the Gulfstream business jet business. The whole industry has never really come back from the 2008-2009 recession. This stat from the industry trade group, I believe there were 1,300 business jet orders in 2008. There were only 661 in 2016. The industry is cut in half. Gulfstream has definitely followed that trend. 

With the tax law, with planes getting older, it feels like that's bottomed out. After a really terrible first quarter, where book to bill came in at 0.7X -- they were shipping out more than they were bringing in -- book to bill jumped to 1.3X. Gulfstream, it's going to take a while. They have new products that are being certified now. That's going to hurt margins over the next few quarters, if they're ramping out new products. 

But there's a sense that that business has bottomed. If they can just get back up toward the numbers from a decade ago, that's really going to help General Dynamics, because they've been in a penalty box because of Gulfstream.

Douglass: Right. And not just from a stock price perspective, but also operationally. 

Whiteman: Definitely.

Douglass: Let's turn to the fourth company, Northrop Grumman, ticker NOC. [laughs] It's funny, Lou and I were talking about this before the show. We both looked at it and said, "There's not really that much interesting here."

Revenue is up 10%. Operating margin declined a fair amount, but tax reform saved the day, so earnings climbed some, as well. Aerospace was up 11%, a lot of that was due to F-35. Have you heard us talking about the F-35s? It impacts Northrop Grumman, as well. It felt like not as unique of a story as the others.

Whiteman: Yeah. This wasn't a bad quarter, by any means, but it was certainly the least good quarter, if we're giving everyone a trophy. [laughs] This is very much a company in transition. They did a very big deal. They bought Orbital ATK, which should help them with space. Space is a very important looking-forward business. But right now, that was a $10 billion deal with debt. There's a long transition, long integration, that's just starting now. 

CEO Wes Bush, the architect of a real transformation at Northrop Grumman and definitely the person behind this deal, he just announced he's leaving in January. Again, it's January, he's staying on as chairman, it's not like something's wrong. But there are a lot of moving parts here. As you said, without the tax benefit, this wouldn't have been a standout quarter. 

They do have the highest percentage classified of any of these guys, so it's tough to read sometimes. Some of that, as you said, the Aerospace, F-35, they also have the B-21, which is their signature program, but that's early days. That's low-margin right now, and a lot of that is classified. 

There's nothing wrong with this company, but this is the least inspired of the four quarters we're talking about, without a doubt.

Douglass: And, of course, a lot of question marks because they have this big integration, and the CEO transition. That's how I'm personally approaching it right now.

Whiteman: This is the least desirable of the four stocks, too, for that reason. They're not at a discount to the others. Again, this is a good company. There's a lot of good businesses. There's no reason to sell this company. But, you feel like it could just take a few quarters. We've talked about growth rates with the others, and we're talking about digestion and getting things together with Northrop. It's the least inspired of the four right now, I'd say.

Douglass: We'll turn to some general trends, and then I'll ask Lou to pick his favorite of the bunch, and we'll talk through that a little bit.

Let's hop back in and talk general trends, or put differently, some compare and contrast between them. When you're looking at Raytheon and Lockheed in particular, one of the things that really jumps out is, missile defense is big, and not only is it going to be big this year and next year, but, probably into the 2020s. That really provides them with a long ramp and a lot of stable business, in a business that can sometimes be a little bit unstable.

Whiteman: Or, at least, there's long lead times. I think that's definitely true. This whole industry, we've had a big swing, and then a swing back. The Budget of Control Act of 2011, sequestration followed that, funding was down. Post-election, single-party control of government. There was a real exuberance that was halted after first quarter earnings, when investors started saying, "Wait, have we gotten ahead of ourselves?"

Real takeaway here for all of these companies -- but especially the two you mentioned, Lockheed and Raytheon -- is that the sense of optimism is back. I don't know if these companies can grow another 50% in share price the way they have in the last couple of years, some of them. If nothing else, those valuations look a lot more sustainable based on the new business coming in. While the first quarter, if not panic, doubt crept in; this was a much more reassuring period, and the outlooks in the guidance, especially, that they're not necessarily going to fall off a cliff.

Douglass: Right. A couple of things we talked about earlier, a lot of classified flowing through. Some attempts to reduce that deferred maintenance in IT. That will almost certainly provide quite a bit for the next year or two, and hopefully a little bit more beyond that, as the government upgrades their various systems.

Whiteman: Right. To put all these numbers in context, the current year budget is about $700 billion. It's the largest in history. That's the Pentagon budget. Of course, inflation comes into that, but it's a $94 billion jump from the year prior. That's 15%. You have to go back to the 2002 budget after 9/ 11 to see a jump that size. 

Obviously, not all of that goes to the companies. A lot of that is military personnel, there's other non-procurement things. But they're going to get a big piece of this. That was the reason for the optimism starting in 2016, and now we're finally seeing it start to trickle into the top line, and hopefully eventually the bottom line. That's the bull case for the industry. It's proving itself out, even if it's taking a while.

Douglass: Right. This is something I've seen in Healthcare and Financials, and it's interesting to see it here in Energy and Industrials, as well. There's this tendency for folks to make predictions. "So-and-so won the presidential election, so-and-so was appointed head of the FDA, so-and-so just got elected to the Congress, here's what's probably going to happen." So, these stocks will immediately react in that way, even though what actually happens might take a year or even two. There's just so much forward-thinking going on in the market once decisions have been made that they expect, for example, bank deregulation; or, in this case, increased Pentagon spending. This expectation gets built-in for so long. Then, when it finally happens it's like, "OK, we knew that. What are you going to do for us now?"

Whiteman: That's a great way to point out, as a word of caution -- who knows how the midterm elections will go? We have an election in the U.S. in a couple of months. I wouldn't be surprised, if we go back to a divided government, that there will be a negative reaction out of fear. That budget deal was a two-year deal. We could go back to sequestration in 2020. 

I don't think that's likely, and I think these companies will be fine either way. There's just so much work to be done. But, to your point, investors in these companies need to be aware that there could be an oversized reaction, depending on how the election goes in November.

Douglass: And oversized reactions, of course, sometimes create awesome buying opportunities.

Whiteman: Absolutely!

Douglass: That begs the question, what's your favorite of these four coming out of earnings, and thinking about what the next couple of years look like?

Whiteman: Sure. I've been beating the drum on General Dynamics for a while now. I'll tell you, Lockheed, who I wasn't that high on, has really gotten me pondering this. But I'm sticking with General Dynamics because of the Gulfstream business. They are not underpriced. They trade at 20X trailing earnings or so. Over the last 10 years, that's much higher than it has been. That's nearly half of the premium given to Lockheed, though. It's a 15% discount or so to Raytheon and Northrop. 

That isn't it because of their defense business. The defense business they have is very strong. That's purely the Gulfstream penalty box. If Gulfstream gets back to the pre-2008 levels, that discount should fade. And I believe it will fade. As I said, there's nothing else wrong with this business. I think, in an industry where everybody's basically competing for the same business, they have the same customer, and the customer wants to make sure none of them gets hit too hard, it's hard to pick out-performers. The opportunity, as Gulfstream heals itself in General Dynamics, I think is the best single idea among these companies, as far as a way to outperform their peers. So, I'll stick with them.

Douglass: Fair enough. I'll say, when I see companies that do fundamentally the same thing, what I'm usually looking for is some kind of advantage, some kind of difference, when I'm thinking about an investment. Going back to the big banks, if Goldman is doing something different from Bank of America and JPMorgan and Citigroup, that's interesting. That's when I start paying attention to what Goldman's doing. In the same way, the fact that General Dynamics has something different about it, it could be a negative or positive, but ultimately, it indicates some potential for difference. 

The key question for investors is going to be, what do you think happens to business jets? And, do they continue to stay on top of that with Gulfstream? It's a strong brand, so I think there's every reason to think, should business jet spending return to pre-recession levels, there's some opportunity there. 

As per usual, the future is impossible to predict, but it's a fun exercise for us, anyway.

Whiteman: Yeah! I think there's a decent chance they at least get their fair share. They're going to be about a quarter or two ahead of Textron, which has Cessna and Beechcraft. If there is demand, General Dynamics will have the freshest products out there. I do believe it's going to work out.

Douglass: Cool. We will check back in on that story in the future, for sure.

Folks, that's it for this week's Energy and Industrials show. Questions or comments, you can always reach us at [email protected]. As always, people on the program may have interests in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. This show is produced by Austin Morgan. For Lou Whiteman, I'm Michael Douglass. Thanks for listening and Fool on!