An Investor's Primer on the Defense Sector

We don't talk about defense sector enough. Investors who bought Big Def in the last few years have seen how profitable the industry can be, and these companies have an incredibly solid customer base and demand that isn't going anywhere.

On this week's Industry Focus: Energy show, host Sarah Priestley talks with sector expert Lou Whiteman about the world of defense. Tune in and find out what this huge industry encompasses, how defense companies work, which players in the space really stand out from the pack, how government customers are so different from private, what to know about the defense market cycle, the most important risks to be aware of, and more.

A full transcript follows the video.

This video was recorded on July 26, 2018.

Sarah Priestley: Welcome to Industry Focus, the show that dives into a different sector of the stock market every day. Today, we're talking Energy and Industrials. It's Thursday, the 26th of July, and we're going to be talking about the defense sector. I'm your host, Sarah Priestley, and joining me on Skype is Motley Fool contributor and all things defense expert, Lou Whiteman. How are you doing, Lou?

Lou Whiteman: Good! How are you?

Priestley: I'm good! Thank you very much for joining us today on Skype, all the way from New York state, is that correct?

Whiteman: Atlanta, actually.

Priestley: Atlanta. Wow! I know nothing.

Whiteman: Other direction.

Priestley: Yes, much warmer.

Whiteman: Yes.

Priestley: You're dealing with the heat wave right now.

Whiteman: Yes, we are.

Priestley: We should say before we start this episode that it has been pre-recorded on the 2nd of July. We had a great listener question about why we don't talk about defense stocks very often. The sad truth of this is, it's a personal failing. I don't know the defense sector very well. Frankly, it's all my fault. 

If you do look at some well-known defense stocks -- Boeing, Raytheon (RTN), Northrop Grumman, Lockheed (LMT -0.20%) -- they're all up over the past year, albeit to varying degrees. In the last five years, they've all doubled in value. It's worth considering the industry, definitely, for some investors. 

Lou, I imagine the current political climate has contributed a fair amount to this rally of late with a very pro- defense Republican in the White House.

Whiteman: It has. Even more so than the party in power, it's the fact that we don't have a divided government anymore. You're right, these stocks, the big names, they are up. Some of them have doubled in the last three years. That has to do, largely, they came off a low base. In the final years of the Obama Administration, with a Republican Congress, you may recall, there were a lot of budget battles. It ended up with the Budget Control Act of 2011, which was sequestration and spending caps. 

There was a hope in the election in November 2016 that the purse strings would loosen with the new Administration. It's taken time, but of course, we did get a two-year budget earlier this year. What you're seeing is, these companies that were at depressed valuations because of the budget battles in Washington have been freed from that, and they're running now. Potentially, they've gotten ahead of themselves. It's on the hopes that, a republican Congress and a Republican president, we're going to see an increase of spending. And so far, it's happening. So far, so good.

Priestley: For my benefit, and for the benefit of listeners, can I ask you a very basic question on the background of the defense industry? What kinds of things does it include? My mind automatically goes to weapons manufacturers and things like that, but it's actually a much broader industry, isn't it, with services, etc.?

Whiteman: It is. The big guns, so to speak, are the names you mentioned, Lockheed Martin being the biggest with an $85 billion market cap. Then, there's a handful of other companies that are focused mostly on weapons platforms -- your General Dynamics (GD -3.97%), Northrop Grumman, Raytheon. The Boeing defense business is only 20% of the company, but it's still a huge contractor. 

Beneath that, though, you have a lot of second-tier companies -- L3 Technologies, Huntington Ingalls is a prime contractor that only does ships. You have a lot of suppliers who make the components. Then, you also have the so-called Beltway bandits, the government services companies that do consulting IT. They do a lot of work for the Pentagon and National Security, but they also increasingly are doing business for the civil agencies -- managing, say the Department of Education's computer systems, and things like that. That's been an area of particular growth in recent years, as some of that IT outsourcing has made its way into the contracting pipeline.

Broadly, I would define the industry as all of these companies. What they all have in common is, they all count on the government or governments as their primary customers. It's a very different animal, dealing with a government entity as your customer vs. dealing with the private sector. It's an area of expertise for all of these companies, that hopefully, they know how to deal with the government and do business with them.

Priestley: What little I do know of the industry is, there's historically been a period of consolidation that's formed what we have now in the U.S. Can you give us a bit of a background on that?

Whiteman: There was constant consolidation. The last big boom was when the Berlin Wall came down, the thawing of the Cold War. The theory was, defense spending would go down because we no longer had any enemies, therefore we needed fewer contractors. That played out into the late 90s, when the Pentagon started getting worried that their supply base was getting too small. They blocked a big Lockheed deal in 1998. That has been the end of prime consolidation. We're unlikely, unless we one day see a transatlantic deal, to see Lockheed buy General Dynamics, or Northrop and Raytheon merge.

The other side of that is, the Pentagon as the primary customer is very mindful to keep these companies healthy. Nothing is guaranteed, but there is a feel that, with any of these companies, there will be a steady stream of business. It's in the customer's best interest to make sure that these five or six remaining primes are healthy and strong. It's not in the customer's best interest to see any of them left out of the pipeline. 

It's an interesting relationship at the top. They buy and sell smaller units all the time, but you don't have that big bang deal. But, you do have a healthy and profitable supply base that you can buy into.

Priestley: I was doing some reading before the show. My knowledge is limited, to put it mildly. I was reading about how defense companies used to work directly with the government solely, and that the U.S. and some other power players really dictated who these companies could work with. Obviously, now, that's changing slightly. Are you seeing the markets opening up and offering growth opportunity for these companies? Or are countries sticking, generally, with operations based within their boundaries?

Whiteman: Increasingly, international is important to these companies. That is one of the offshoots of what happened in the later years of the Obama Administration, where the Pentagon was at least slowed, if not crippled, in what they could buy. Raytheon in particular has a goal of getting 50% of its revenue internationally. We've seen all of these companies look abroad. They've also tried to diversify, in terms of some of the IT units going to the states and going local. 

But, yes. There are limits. With the Trump Administration, these limits are changing and maybe loosening some. They're selling to allies, but increasingly working with the government. The Patriot missile from Raytheon is a great example. The THAAD system, which is an anti-ballistic system made by Lockheed, has been in the news with the North Korea threat. 

There are opportunities overseas. It's a different world. It's slow growth. But with the U.S. government's backing, with allies, there has been increased growth internationally. This is the way they can diversify. You can't diversify by saying, "Fine, we'll sell our tanks to both the Pentagon and General Motors." You have to diversify with other countries and working with allies. The federal government is largely supportive of that, if only because it can spread research and development spending and maybe bring down prices in the long-term for the Pentagon.

Priestley: I actually used to work for a foreign aerospace and defense company -- which obviously makes this lack of understanding a bit more embarrassing. One thing that was particularly up for debate for us was where we invested outside of the country on defense contracts. There was usually an exchange of IP, too. That was very much a debate of, how much IP do you keep for yourself, and how much do you trade as payment for investing in these markets? I know that's also a concern.

Whiteman: You're seeing that play out right now with the F-35, which is a huge program. It's going to be a trillion-dollar program, the Joint Strike Fighter for Lockheed. It was supposed to go to our NATO ally, Turkey. But Turkey right now is a very different country than the Turkey that was part of NATO and ordered those planes. There's talk of lawmakers now blocking that sale. It's not going to sink Lockheed, but there's a constant challenge, even among NATO, even among allies, of where technology goes. The government is definitely mindful of that.

Priestley: To get to the meat of the discussion, the thing that everybody's interested in hearing -- what would you consider to be top stocks within this segment?

Whiteman: If you think about the picture we've painted, of an industry where you can't really consolidate at the top, and everybody is getting some share of the pie, the hard part is to find the over-performer. For me, among the primes, it's General Dynamics right now, because of their non-military business. They have an aerospace unit, Gulfstream, which makes business jets. That whole sector has not recovered from the 2008 recession. Gulfstream has struggled. General Dynamics has been in the penalty box. If you look now, compared to their peers, they are now a 15% valuation discount, in terms of price to earnings, maybe a 10% discount price to sales, to a Northrop or a Raytheon. 

There's reason to believe that Gulfstream and business jets are slowly coming back. The tax law has changed depreciation, which helped. Slowly, the fleet is aging, and companies are forced to look at business jet replacements. The used inventory is getting more expensive. 

It's going to be slow, but I do believe the business jet market is coming back. Gulfstream is going to be a real beneficiary of that. They have really good new products coming on the market. I believe slowly, over time, maybe it's going to take the next three of four quarters, you're going to see Gulfstream come back, you're going to see the market reward that. Even if they just close the valuation gap they have with the others, that's a chance for upside that you might not see in the others, which are very fully valued. So, I really like Gulfstream right now.

Priestley: I would agree with you. A lot of people listening probably think "private jets" and their mind immediately goes to these billionaires as individual buyers. Actually, the bulk of this market is corporations. When came the 2008 financial crisis and all that came with that, there's very much the perception of austerity at that corporate level. As we're starting to see a shift and everybody calming a little bit -- there's always fears, after, in recent memory, you have such a profound recession. But definitely, we're starting to see spending on the up at the corporate level. That's what will drive this market.

Whiteman: If nothing else, it's bottomed out, and it's slowly coming back. Gulfstream is in a good position. They have new products coming out ahead of their archrival, which is Textron Cessna. As this comes through, I think you're going to see Gulfstream hopefully outperform their rivals, but if nothing else, if they could just get back toward where they were ten years ago, General Dynamics' stock, that's the reason for the discount. Hopefully, and I believe, as Gulfstream recovers, you're going to see that discount close.

Priestley: Then, on the services side, you mentioned a couple of companies earlier that you thought were interesting.

Whiteman: Sure. Leidos (LDOS 0.17%) is the one I would look at more than anything. The ticker there is LDOS. They, thanks to a deal in 2016 that purchased the IT business of Lockheed Martin, are the largest business in terms of revenue in an area where scale is very important -- manpower, getting these big contracts, the contracts are ever-bigger. With the budget deal passed earlier this year, a lot of this IT work is what got pushed to the sidelines or delayed. They weren't going to stop buying F-35s because of sequestration. What they did was, they stopped awarding these IT contracts. 

Most of these companies, Leidos included, are forecasting a very strong back half of 2018 as these contracts get done. Leidos is going to be the primary beneficiary of that, if not one of the top beneficiaries. They have a $4 billion defense healthcare deal that's going to cycle in. 

It's pretty expensive. It's 23X earnings on a trailing basis. But, assuming that business comes in -- and I do think we're going to see it in the second half of this year -- the price looks a little more attractive with that P/E coming down. They're the winner in a space that should out-perform over the next year or so. I think they're a good company to look at.

Priestley: Another one I wanted to mention, because, living around D.C., you see all these names so frequently. Any time you drive out to the airport you go through Reston and see all of these names. What about Booz Allen Hamilton?

Whiteman: Yes, which is, unfortunately, best-known now as the place where Edward Snowden worked. They still have some of that legacy, but they are very well-run company. They have a unique culture where they are very focused on the consulting end, too, which tends to be higher margin. 

There is a little more risk there, because they do have ongoing investigations, not so much with Snowden, but there were some billing inquiries. I don't think anything is going to come out of that, but you should definitely look into that. But, that's a very solid company for a long-term hold. They're not going to be the biggest. They're haven't participated in the consolidation in the way some of these IT players, like Leidos, did. But this is a well-run company that I really like as a long-term investment.

Priestley: Is there anything else you want to add before we start to wrap up the show, that you think investors looking into this space should know?

Whiteman: A couple of words of caution, what to look for for what could go wrong. As mentioned, the deal that we reached in budget caps, it was a two-year deal. That means, fiscal year 2020, we could see those caps go back in place. There's a lot of reason that should not happen -- not just on the defense side, but on the civil side. Inflation has occurred over the few years, and the government needs to be spending more than those cap levels. 

That said, D.C. is not a rational town. I do believe, depending on how the midterms go, if we end up with a split government, the current Administration is going to find it very hard to make a budget deal, and that's a risk. What we saw before is, Wall Street was definitely well-aware of that risk and probably overly punished the stocks. If you're buying in now or holding these stocks, be aware, long-term, the companies will be fine. You're not at risk of losing your money. But short-term, it could be very turbulent for these companies, if November doesn't go the White House's way.

Longer-term, in terms of the cyclical nature of this business, it's definitely a cyclical business, but also, it doesn't go with the business cycle the way other industries do because it's so reliant on the government. That's both a frustration, but it can be a good thing. I think back, in the late 90s, I was doing venture capital in Northern Virginia. Everybody made fun of these government services companies. Why would you want to do business with the government? Then the tech bubble burst. It was really funny, over the next few months, the companies that happened to make it through that that were mocking the government were all the sudden pivoting to the government. 

That's a good reminder. The Pentagon is a boring customer, the federal government is a boring customer, and there's lots of drama. But it's also a customer that, at the end of the day, is more likely to pay its bills than being the server farm for eToys. 

As you're picking a long-term sector, that's my little pitch for the defense industry -- the world isn't getting safer, there is turbulence, there is political drama to put up with. But these are well-run companies selling a product that's in demand to a customer who, at the end of the day, can pay for it. Especially for really long-term holders that just want to sleep at night, this is a good sector to look at.

Priestley: Excellent. That's wonderful! Thank you so much for sharing your expertise with us today! Thank you very much, Lou!

Whiteman: Thank you! It's my pleasure!

Priestley: That's it from us today. If you would like to get in touch, please feel free to email us at [email protected], or tweet us on Twitter @MFIndustryFocus. As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thank you, as always, to the marvelously patient Austin Morgan for mixing the show. For Lou, I'm Sarah Priestley. Thanks for listening and Fool on!