There are big doings Down Under, as we learned last week, and it looks like they're going to benefit two of America's biggest defense contractors: L3 Technologies (LLL) and General Dynamics (GD 1.25%).
On June 26, the U.S. Defense Security Cooperation Agency (DSCA) notified Congress of a pending sale of five modified General Dynamics Gulfstream G550 jets to the Royal Australian Air Force (RAAF). Originally built as a business jet, the G550 can be converted into a militarized Airborne Intelligence, Surveillance, Reconnaissance, and Electronic Warfare (AISREW) platform with the addition of secure communications, aircraft defensive systems, and other equipment. And that's what the Australians intend to do.
In fact, as Australian Aviation reported early last year, it's something they've been doing for a while. In January 2016, AA described a RAAF acquisition of two Gulfstream G550s, which was later confirmed in FlightGlobal's World Air Forces 2017 report. This latest deal to acquire five more G550s appears to be in addition to the two acquisitions reported last year.
As AA explained at the time, Australia's goal in buying the planes appears to be to create a dedicated force of electronic intelligence-gathering (ELINT) aircraft to replace the role previously performed by its 15 AP-3C Orion surveillance aircraft, which are in turn being retired in favor of 10 new dedicated maritime surveillance P-8A Poseidons from Boeing.
Replacing 15 multi-role aircraft with at least 10 maritime surveillance birds and, now, seven ELINT aircraft should significantly enhance the RAAF's capabilities. Indeed, DSCA explained that the sale "supports and complements the ongoing efforts of Australia to modernize its Electronic Warfare capability and increases interoperability between the U.S. Air Force and the Royal Australian Air Force (RAAF)."
What it means to investors
DSCA named L3 Technologies as the prime contractor on this sale, which is valued at $1.3 billion. That makes a lot of sense, because while General Dynamics builds the bare-bones G550, it's pretty clear that L3 will be making the most money from this deal. Here's why:
According to AirCompare.com, the list price on a new Gulfstream G550 is just $57 million. (And the last two G550s Australia bought were even cheaper.) Multiply that by five aircraft, and that works out to at most $285 million of this $1.3 billion deal flying into General Dynamics' coffers. The remaining $1 billion and change, therefore, must be attributed to L3 Technologies for the modifications it must make to convert these business-class birds into warbirds.
Now, this doesn't mean that General Dynamics won't still turn a nice profit on this deal -- it will. According to S&P Global Market Intelligence, General Dynamics' aerospace division (i.e., Gulfstream) earns 20.5% operating profit margins on its products. On a presumed $285 million in revenue from the Australia deal, this should produce $58.4 million in pre-tax profit for GD.
L3, on the other hand, earns margins of just 6.8% on its aerospace systems. Applied to perhaps $1 billion in revenue, that implies that L3 could walk away from this deal only $68 million richer -- hardly more than General Dynamics will make, prime contractor or no.
Long story short: Investors may be paying 20 times earnings for both of these stocks today. But given the vast differences in profitability, I know which stock I'd prefer to own based on the performance of its aerospace division: General Dynamics, hands down.