At the risk of repeating myself, Boeing (NYSE: BA ) is cheap.
How do I know this? Why do I keep saying it, despite Wall Street insisting defense stocks aren't worth the virtual paper their share certificates are printed on? Because the prices serious investors pay for defense stocks continue to outrun the companies' market prices by a significant margin -- the latest evidence of which arrived with the morning paper.
Rumor becomes fact
On Monday, Applied Signal (Nasdaq: APSG ) confirmed a rumor that has been floating around for months: It's indeed being bought, by Raytheon (NYSE: RTN ) , which beat out Britain's Cobham, as well as SAIC (NYSE: SAI ) and L-3 Communications (NYSE: LLL ) here at home. Now, this wasn't exactly a secret -- but it was a surprise. Offering $38 per share for its new prize ($490 million in all), Raytheon will pay a whopping 2.25 times annual sales for Applied Signal -- 80% more than the company cost in August, and more than three times the price-to-sales ratio that Raytheon's own shares command today.
This is for a company that's growing faster than Raytheon proper, I'll grant you -- but one that earns barely half Raytheon's return on equity, and boasts a smaller net profit margin to boot. The price hardly seems a bargain and yet, it does tend to support the thesis I've been presenting here since, oh, about March.
To wit: Any defense company that can earn a decent operating margin (say, 10%), and show a respectable growth rate (again, 10%, give or take), should, by and large, sell for a market capitalization equal to or greater than the amount of revenue it brings in in a year. The "right price" for a defense stock like Boeing, therefore -- 8.1% operating margin, 9% growth -- is going to be a hair or two shy of one times sales.
The market speaks
How do I know this thesis is correct? Because the market is telling me so. Consider:
- Last year, Northrop Grumman (NYSE: NOC ) sold its TASC consulting division to General Atlantic and KKR for $1.65 billion, a price equivalent to one times sales, nearly to the decimal.
- In January, Boeing bought Argon ST for $775 million -- 2.5 times sales.
- Two months later, Orbital Sciences paid 1.1 times sales to take General Dynamics' (NYSE: GD ) satellite manufacturing division off its hands.
- In August, FLIR Systems anted up 1.5 times sales to acquire tiny ICx Technologies.
- Followed by Lockheed Martin selling its Enterprise Integration unit (EI) to Veritas Capital for 1.3 times sales.
Anybody see a pattern here?
And now, here comes Raytheon confirming the pattern once again. It has spotted a defense shop it likes, and is paying well over the one-times sales threshold to acquire it. And I say: "Good for it." With an operating margin well over my 10% threshold for "one times status," and a growth rate even more-above average, I believe Raytheon's purchase price is fully justified by Applied Signal's prospects. The fact that investors aren't really punishing Raytheon's stock all that much tells me they may be starting to come around to my way of thinking, too.
Of course, unless you're in the arbitrage business, all this is probably pretty moot to you. If you owned Applied Signal before the news broke, you're rolling in dough this morning. Congrats. On the other hand, if you didn't own it, chances are that Raytheon's $38 offer isn't high enough to make you want to jump in and pay the $37.78 price tag on Applied Signal's stock today. A better use of your time, though, is to seek bargains elsewhere.
So once again, I submit the following shopping list for your consideration:
Potential Profit at One Times Sales
|Boeing||$65.7 billion||$47.4 billion||39%|
|General Dynamics||$31.8 billion||$26.6 billion||20%|
|Textron||$10.2 billion||$6.4 billion||59%|
|Lockheed Martin||$46.4 billion||$25.3 billion||83%|
|L-3 Communications||$15.6 billion||$8.0 billion||95%|
Foolish final thought
Fools, I cannot say for certain that all of these stocks are worth precisely one times sales, and that they'll ultimately sell for the value of their annual revenue streams. What I can tell you is that seems to be the way things are heading.
Since I last ran valuations on this list, both General Dynamics and Textron have narrowed their price-versus-value gaps -- Textron, significantly so. Boeing looked to be heading that way, too, until its latest round of Dreamliner delays put an end to that trend. Why, even the ceaseless stream of bad news on the budget front hasn't set back Lockheed and L-3 Communications all that far.
Meanwhile, everywhere you look, defense contractors and savvy private equity players continue to pay the one times sales ratio -- and more -- whenever a defense shop goes up for auction. My hunch: These discounts won't last forever, and perhaps, they won't last long.