In this episode of Industry Focus: Energy, Motley Fool Contributor Lou Whiteman and Industry Focus Host Nick Sciple discuss the defense industry, with a particular focus on investing in companies executing classified projects. Spending on classified projects is outpacing Pentagon spend overall, making classified work a potential growth sector within the defense industry. In their conversation Nick and Lou cover potential opportunities in the sector today, the challenges of investing in and evaluating businesses that perform classified work, and share some companies that are worth adding to your watchlist. 

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This video was recorded on October 15, 2020.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. Pentagon watchers got a surprise late last month when the Air Force revealed it had designed and built a prototype of its next fighter plane. Remarkably, the entire development process, likely coordinated with multiple defense contractors over the course of many months, was completed without any rumors leaking about the program. This aircraft is just the latest example of how little we know about the cutting-edge of military defense and how much investors are kept in the dark about where the Pentagon spends its money.

On this week's episode, Motley Fool contributor Lou Whiteman joins the show to take a look at classified defense spending and what it means for defense investors. Lou, welcome back on the podcast.

Lou Whiteman: Happy to be here.

Sciple: Great to have you on. As always, we've got a fun topic this week talking about classified projects in the defense industry. Before we dive into some of these projects and maybe how you should think about them as an investor, just high-level, maybe this is an obvious question, but why are there so many classified projects with the U. S. military and with militaries, in general?

Whiteman: You know, dissertations have been written on this, so we won't go in too deep. But on a very simple level, the Pentagon will argue that secrecy is the key to military superiority. We can't let our rivals, our enemies, know what we are working on. No different than a football coach hiding the playbook. But in fairness, the critics will say, and they're right, there's a lot of secrecy, that leads to limits on oversight, that can hide waste. There's a lot that can go wrong with it, and it's a constant moving target as far as what's too much and what's being done.

Sciple: So, when we talk about classified defense work, how big is that market relative to the overall defense budget?

Whiteman: So, classified is more than 10% of the total Pentagon budget, which was $721 billion in fiscal 2020. Now remember, that also includes a lot of payroll and a lot of noncontractor stuff; it's probably well north of 25% of total procurement spending for contractors, and it's rising. We saw it go down after the Cold War, but in recent years classified growth is outpacing total Pentagon budget growth, and up by a decent margin.

Sciple: Which makes sense, obviously, new technologies, typically classified projects are going to be on the cutting-edge; the secret special sauce you don't want your opponents to know about. Obviously, there's not a lot of disclosure when it comes to these projects, but from an investor's point-of-view what disclosure do we get on classified projects that companies may be participating in?

Whiteman: So, we get very high altitude generalized guidance. Most defense contractors will break out their classified bookings, their classified revenue, they won't tell us specific programs, they will hint at it on calls and you can get an idea of what's going on, kind of, just based on the company. These companies do different things. Lockheed Martin (NYSE:LMT) is getting a lot of classified work that is presumably hypersonic missiles, for example. Northrop Grumman (NYSE:NOC) has a lot of space. Also, they have the B-21 bomber that is still largely under wraps.

The point being, though, and the real interesting thing in here is that, whatever disclosure we get, it created a hole big enough to hide a new jet fighter in, [laughs] which I think speaks volumes to how little we know about what's going on.

Sciple: Right. And I want to bring up that jet fighter that we talked about off the top of the show, what do we know about that so far? [laughs] Like you said, we don't know who's developing it.

Whiteman: No, we don't. Well, we know that the Air Force is taking the lead on this, which is interesting, and we can talk about that in a second. But it was developed in just over a year, which is a crazy short timespan for one of these projects. It is, in theory, a replacement for the F-22, a Lockheed Martin plane that has largely been a dud, it's never going to be what they thought it was. In part, not its own fault, the F-22 was developed in the end of the analog age, it has been hard for this plane to keep up with the digital transformation, the fly by-wire and the radar, the sensors, the working together of the electronics that we've come to use since. This is the replacement, and it speaks to, I think, where the Air Force wants to go, which is really where this is interesting, just the fact that they did this alone, but this is a different way to build an airplane.

Sciple: Yeah. I mean, that speed of time-to-market is really significant, how do you think that this airplane will be different from the F-22? You mentioned more digital native technology. What should we be paying attention to there?

Whiteman: I think they borrowed heavily from the F-35, and probably learned a lot from the F-35. The F-35, for all its problems, is a much better airplane. With the pure fighter, the F-22 had to be a lot faster. So, it's not going to be a replica of the F-35, which was designed to take on a lot of roles, but I think you are going to -- it's most likely a next-gen and highly, highly upgradable version of an F-22, with the speed and stealth characteristics, but a lot more, probably, miles and miles more wiring that you had on the F-22.

Sciple: Absolutely. So, the big question everybody has right now is, who is the company behind this new aircraft? You look at some comments from Will Roper, who is the Head of Acquisitions for the Air Force. And he suggests that it might not be some of these names that come to mind, that there could be some companies that aren't traditional defense contractors that are playing in the space. Do you have any thoughts on who the potential names might be out there?

Whiteman: Yeah. And Roper's quote, and I'll read it to you because it really is interesting, because it's not very subtle, said, I have to imagine there'll be a lot of engineers, maybe famous ones, sort of, well-known household names and billions of dollars to invest that would be curious about this. I mean, he's just screaming out for Elon Musk and Jeff Bezos there, [laughs] right, and some of their activities. For this, I would be really surprised if it's one of them.

It's probably one of three suspects, it's either Northrop Grumman, Lockheed Martin, or Boeing. If I had to guess, I would guess Lockheed, but the odds may be 20% that it's not. The real, real interesting thing here, though, for investors to take away is that it might not matter. In the past, these planes have been franchises; multidecade, just powerhouses. The F-35 is going to bring in $1 trillion for Lockheed and its subcontractors. The Air Force would like to shift to almost more -- it's a weird analogy, but almost an automobile model, where you have a number of companies putting out platforms that they update every few years, and it's a constant state where the Air Force is buying smaller lots for a couple of years and then re-competing, with the idea being that some of this digital transformation that allow them to design a plane in a year, as this improves, it'll bring down the total R&D costs. And it can be, say, you have three or four contractors who are constantly, even if they're not in production, are constantly designing planes. And instead of having just a flag post, this is our program for the next 10 years, that you're going to buy for two years from Lockheed and then Northrop can get back into it. That opens up a lot of opportunities, it ends the winner take all mentality, over time it could really work out well for these companies, because other than Lockheed Martin, Northrop and Boeing, they have been shut out since the 80s on new planes.

Sciple: Right. So, getting rid of some of that lumpiness, maybe there can be more new entrants into the market, and I imagine, the Air Force would appreciate having a more diverse subset of potential suppliers.

Whiteman: Yeah, and constantly upgrading their product. And it could be a win-win, but it's crazy to think of it versus how it's been done before.

Sciple: Right. So, when we talk about these projects, like the aircraft where there's a physical thing out in the world that people can see, that's one category of classified technology, classified secret. However, there's a whole other genre of classified programs where we're talking about spies, counterespionage work, the type of thing where there's not a physical good out in the world that you can see that's classified, it's information that's classified. What types of public companies do work in those types of fields of classified defense work?

Whiteman: So, these are the companies, the so-called Beltway bandits that you see, if you ever had the pleasure of driving from Washington, D.C., out the Dulles Airport: ManTech, Booz Allen Hamilton, SAIC, CACI, Leidos Holdings, General Dynamics. Some of the big guys have really big portfolios here, too. But, yeah, these are the government services companies. And they do a ton of work; it's not all classified. A lot of it, is they run the email systems for Health and Human Services. There's a gradual outsourcing of the Federal government's IT, and these government service companies do a lot of that work. But also, a large and growing business part of their business is classified, is intelligence, is spy agencies, not just the Pentagon.

Sciple: Right. And when you compare these types of programs relative to, you know, the aircraft that we talked about earlier, is there a different margin profile or is this type of work a bigger subset of the defense budget relative to these real projects or any thoughts there on color?

Whiteman: Comparing it to hardware is a little weird, because margins vary by product. In general, some of those services can be commoditized, so you see low margins on, say, running the email servers for Health and Human Services. Classified can stand out, that business tends to be stickier and it tends to be higher margin, in part, because it's harder to commoditize. You have specialized skills, specialized training; you can't just flip it every two years to a new contractor.

You know, it's interesting, it's also led to a lot of the M&A in the sector. It can take years to get workers clearances, and a lot of the lack of growth in years past for these companies have been, we just can't get enough classified employees to bid for this work. The easy way around that is to buy a whole bunch of cleared employees through an acquisition of a smaller company. So, it really does fuel a Washington DC, kind of, a food chain from the bigger swallowing up the smaller, almost to get the assets, the people, more than it is the business.

Sciple: Right. It's that acquihire mentality. You see that playing out somewhat in autonomous drive, that is another area where a lot of companies, there's only so many folks who have the expertise in the underlying technologies you need to grow in that industry, and so you see lots of acquihiring going on to try to gobble up that talent.

When we talk about these companies that are engaged in this espionage, counterterrorism-type work, that the company that is at the top of a lot of investors' minds right now is Palantir; that's a company backed by Peter Thiel. They played a role in the hunt for Osama Bin Laden a number of years ago. And the company has gone public in recent weeks. When you look at Palantir, what are your thoughts on that company today?

Whiteman: It's interesting. I mean, what are they? Because I know what I think they are, but I get a lot of pushback [laughs] on Twitter when I say what I think they are. This is a company that is born in Silicon Valley and it's born with that mindset. Notably, they've moved out of Silicon Valley, in part because they are very, very angry about stuff very relevant with what's going on with Twitter right now. So, they have a different, I guess, ethos, they have more of a government ethos. But more than half of their revenue comes from the government, most of their lucrative work, although it's hard to really get at that, but there's a real simple reason why they don't necessarily want to look like one of these government services contractors.

Booz Allen Hamilton is about the best-run government services firm you can get, it trades about 1.5X sales. Private companies like Splunk, I think that's trading at 13X sales. Salesforce paid 10X sales for Tableau. Palantir right now is hoping to get to $1 billion in revenue this year. Their market cap is $20 billion; that's a 20X sales forward multiple. It's really easy to see [laughs] why you don't want to be lumped in with a group of companies that are trading at 1X or 2X sales. But to me, what they are doing is they are doing the same work and I think that's what most of the business is. So, that's kind of how I view them right now.

Sciple: Right. And so, you think the way the market is viewing it, it is more of a technology company, when you drive down into what the company actually does and their margin profile and that sort of thing, it looks much more similar to these other defense contractor firms?

Whiteman: Right. And I think there's real risk here too, because I think there is this perception in one sense that they are a private commercial company. But as you say, notably they were involved in the hunt for Osama Bin laden. Their technology right now is being used to target a lot of drone strikes, and that is controversy. Also, their software is used by Homeland Security's Immigration and Customs Enforcement division; everything you've seen at the border. And you know, I don't want to have the debate, right or wrong, whether they should do it -- they had some really, really pointed statements in their S-1 about, look, if our government is doing this, they deserve the best technology and we're doing it. And that's one argument, but I'll tell you that it made them a target of a lot of groups. I think investors need to decide for themselves, but be warned that this collection of contracts, which is the heart and soul of their business, it's a lightning rod, it's hard to imagine over time that it doesn't have some limit to the attractiveness of the shares for some investors, and it could weigh on the shares over time. Right or wrong, it's just something to consider when you look at this company.

Sciple: Yeah, I think it's a fair point to bring up. It can put a bad taste in some investors' mouth, just some of the activities that they participate in. However, you know, if you want to take the other side of that coin, there aren't a lot of people rushing to provide services to this industry, and Palantir could have a limited number of competitors for that reason. Before we move on from Palantir, just kind of a high-level question, how big do you think the market is for this company? You see this development of data analytics work and its role in spying and that sort of thing, do you think that's something where the market for defense spending is growing as a result of the services that Palantir is offering or is it something where the nature of defense is changing and Palantir is just grabbing a piece of the same pie that was already there?

Whiteman: I think it's grabbing a piece of a growing pie. It's really hard to put a number on it. Government services revenue is probably somewhere in the ballpark of $30 billion to $40 billion annually, but there's a lot included in there. This dark stuff, the spy stuff, is a much smaller portion of that, but it is a growing part of it, and the government is becoming more and more reliant on these contractors to provide it.

I will say this for Palantir, I guarantee you, every other one of these Beltway bandits would love to have their technology. And so, they are going to be taking business, but it is a growing pie that they're eating out of, so I don't think it necessarily dooms anyone else.

Sciple: Sure. Before I move on from classified investing and talk a little about the budget and some of those topics, any just, kind of, final thoughts on investing in these classified companies, you look at a company like Palantir, you're not going to get a great look at the nature of the work that they're doing and that sort of thing, how do you think about investing in these types of companies?

Whiteman: Oh, yeah, and it's a lot of them too. I mean, ManTech I was just looking at, I believe, 45% of their bookings last quarter were just classified, so who knows what it was. The one thing I'd say is that, the payor here, the customer, is the U.S. government. In terms of just buying blindly, knowing that the U.S. government is on the other side of the transaction, knowing their ability to pay the bills, and knowing how hard it is to just announce a made-up contract, I think it's not as blind investing as you might think and it really doesn't matter if the contract is with the NSA or spying agency. So, I don't sweat the details on this, you got to accept some uncertainty, but it's not like it's, you know, a prince via email promising you [laughs] those contracts, it is the U.S. government providing the cash at the end of the day. So, that allows me to sleep at night anyway.

Sciple: Yeah, I think, one last thing that I'd remember as well, is right, you've got a customer that, [laughs] you know, not going to go anywhere anytime soon, and then two, like you said earlier, there are significant barriers to entry to providing some of these services just because of how hard it is to get your necessary clearances and all that sort of thing. So, you're in an industry where it's unlikely you're going to see lots of new entrants to compete with these folks that are already in the market. And so, while there is some concern about transparency, there is somewhat lesser concern about new entrants. And so, you know, there's a give-and-take there.

Before we go away, Lou, I'd be remiss if we didn't at least spend some time talking about the budget, the Presidential election is less than three weeks away, and the defense industry, as you mentioned, their primary customer is the U.S. Federal government. Defense stocks, in particular those that are government services companies, we mentioned earlier, have underperformed the market this year on fears of a declining Pentagon budget, are these concerns justified in your opinion, how are you thinking about the new budget with the election coming up?

Whiteman: So, it's not unusual for these stocks to be under pressure in an election year, and it has played out this year as you've said. You know, the Pentagon planners, they were preparing for flat budgets these next few years regardless of who wins this election. We've had a couple of really good years of growth. Even two years ago they were signaling, this is going to have to end. COVID-related spending, a lot of government borrowings, there's a lot of more new pressures that we couldn't anticipate a couple of years ago, but we were headed for a flatline budget and nothing has changed that.

That said, we are in a period of modernization. We spent a long time after the Cold War either cutting back on Pentagon spending or funding Middle East campaigns, instead of really modernizing or looking to the future. The Pentagon is in the middle of a modernization effort, that means big spending on equipment, big spending for contractors and R&D. The White House is committed to this, the Biden campaign is committed to this, I don't think that's going to disappear and I don't think it's going to dry up. And meanwhile, thanks to these last few years and some of these contracts given out, most of the majors have tens and tens of billions in their backlog that look pretty safe. So, they can actually grow the business even on a flat budget the next few years. We can't have this indefinitely, but I'm not worried about it right now.

Sciple: So, this is something we didn't have in the notes, Lou, but I just thought about it, and it's maybe a fun question: do you have any concerns about the Space Force if there's a change in the administration?

Whiteman: No, because a lot of that, without being political, a lot of that was happening anyway, and it's just putting a new fence around it. And this is an important part of the modernization effort, and even if Space Force was to be backtracked and just put back into mostly the Air Force, I can't imagine a lot of those priorities, if anything, if they were to decide to put Space Force, kind of, back inside the Air Force, there'd personnel adjustments, there'd be spending adjustments on that side, but the big programs, the big priorities, those are years before Space Force and they're not going anywhere.

Sciple: Okay. So, when it comes to the budget, you know, keep calm and carry on when it comes to investing in these defense companies. Last thing before we go away, Lou, I always like to ask, what's a defense stock that's on your radar that you think listeners should be paying attention to right now?

Whiteman: When you talked about the budget, and you mention correctly that the government services companies have been particularly hard hit, and that's because the last time we had a flat to shrinking budget, the sequestration in the later end of the Obama years, government services is where most of the cost cuts were found. That didn't work out too well. Edward Snowden [laughs] came in that time. We had a lot of other IT issues. We also were fighting a lot of wars in the Middle East that drained a lot of the budget. I don't think the Pentagon is going to make the same mistake twice. If anything, I think they are going to overcorrect and make sure government services IT modernization is not where the budget cuts happen this time. I think the government services firms are being overly punished by a worried market, I like a lot of them, I think Leidos, SAIC, Booz Allen.

The one I really like is ManTech right now, and you can put a link to that. ManTech is a smaller company, it's a lot of these classified areas that should be sticky, and it's also small enough that it could either be a buyer or a seller in a consolidating market, so you have a lot of ways to win. ManTech is the one I'm really curious to watch in the next six months what happens.

Sciple: Yeah. For our listeners who aren't familiar with that company, what's your elevator pitch? Obviously, they're in this government services sector, what stands out for them relative to these other companies?

Whiteman: So, they're a 50-year-old company, but they are a turnaround story in a way, because they were doing a lot of the grunt work services, they were running the canteens in Afghanistan 10 years ago. And as that business dried up, they got heavily into IT and used mergers and acquisitions to do it. They are a huge part of the top secret, of the classified arena now in terms of a lot of their specialized analytics, and they seem to be pretty good at it, they are taking share. They also have a Founder and Chairman who stepped back from CEO a few years ago and just now has stepped back from being the Executive Chairman. They were never going to sell under him. As he steps into the background, I think a lot of things could open up, either as far as getting aggressive, doing a merger of equals, doing bigger deals or finding a buyer, there's a lot of ways to win on this company in this space and it's very interesting right now.

Sciple: All right. So, the ticker on ManTech is MANT, if you want to add that to your watchlist. We'll be paying attention to all these defense topics as they come down the line. And Lou, we'll be looking forward to having you on the podcast once again to break it all down.

Whiteman: Always a pleasure.

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear.

Thanks to Tim Sparks for mixing the show. For Lou Whiteman, I'm Nick Sciple, thanks for listening and Fool on!

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.