Motley Fool contributor Lou Whiteman joins the show to take a look at earnings reports from Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), and General Dynamics (NYSE:GD), as well as the overall state of the defense industry.

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This video was recorded on Oct. 28, 2021.

Nick Sciple: Welcome to Industry Focus. I'm Nick Sciple. Following a round of disappointing earnings reports. It's been a rough week for defense contractors stocks. Today, Lou Whiteman joins the show to update us on the state of the union and the defense industry. Lou, thanks for joining me.

Lou Whiteman: Glad to be here, Nick.

Nick Sciple: Great to have you. As I mentioned off the top, you've got some big moves this week. Lockheed Martin down over 10 percent. Northrop Grumman reported earnings this morning they've declined quite a bit. What's going on here in the broad market? Why are the turmoil in these defense stocks?

Lou Whiteman: We have a lot of things hitting at one. For one some of this is just supply chain issues, COVID, what we're seeing or general industrials. Some of these with the chip shortage where we've heard about with autos that hit on to some of these supply chains. We also have the chaos of the Afghanistan withdrawal that really didn't affect sales. In terms of we're not going to buy fewer F-35s because we're pulling out of Afghanistan. But there is a lot of transition and a lot of turmoil in the Pentagon and that is affecting just how business is getting done. You add into that just a changing shift in priorities at the Pentagon. A lot of these companies, the tale they're telling, if there's optimism, it's down the road, it's not in the immediate and the markets does not like to hear that.

Nick Sciple: You mentioned the Afghanistan pullout. Obviously, this was dominating the political headlines a couple of months ago with the nature of how financial reporting works for a couple of months down the line. Now, we're getting earnings reports that swallow up that change and companies are adapting. We've been at war for better or worse, better part of 20 years, and now, we're not or we're in a different way and that's the industry is changing.

Lou Whiteman: Arguably, for the long term. The shift from Afghanistan to what they call great power conflict which is basically Russia and China. What are they up to? That's bullish for defense contractors simply because Russia and China are building a lot of very sophisticated high-tech weaponry. We need to match versus the insurgents into desert where maybe you don't need the best and the brightest, but it is a transition and it will take time to play out. This shift is both going to drive earnings power in the second half of the decade, but it's really hitting hard right now.

Nick Sciple: You mentioned in these hypersonic weapons, the next-generation of war fighting folks price all lots of headlines about China testing hypersonic weapon that has raised some potential concerns well the folks helping develop those weapons for at least the US military is Lockheed Martin, which reported earnings earlier this week. What did we see from Lockheed's earnings report.

Lou Whiteman: Lockheed actually beat on earnings, so they'd be pretty healthily 221 per share versus a 197 estimate. But that was down 65 percent year over year due to a pension charge. We knew that was coming. The real focus and the real reason for the drop was revenue. They missed by more than a billion dollars, it was down year-over-year. That caused the stock to really trade-off. They listed a lot of reasons. We went through the laundry list, decided go supply chain issues. In Lockheed's case, the F-35, they're trillion-dollar program. We're seeing production cuts and we may never see the full production, the United Kingdom nationalized weapons contract that had been with Lockheed for a while. Again, we knew that was coming, but all of these things hit at once. Then you also have a new CEO there. You have an interim chief financial officer. I think that some of this was a housecleaning quarter where they're just going to get everything out now and then resetting expectations. But all-in, there wasn't a lot to be excited about. You add to it that they cut their full-year revenue guidance and warn the growth in 2022, their pending acquisition of Aerojet Rocketdyne, which is going to build their space business. That was supposed to close this year, but the Biden administration isn't sure what they think about that. That's falling into 2022. It was just a cascade of a million cuts where they really didn't have a lot positive to say about the rest of the year and heading into 2022.

Nick Sciple: As you look at that 2022 revenue guide, I think there are a slight decline projecting, but as you look out further, the management says, as you look out further throughout the decade up through 2026, we should start resuming some growth in 2023 and going forward, what's really going to be driving that for the businesses that closing this space acquisition and some of these other projects. What should we be paying attention to going forward?

Lou Whiteman: So a couple of things, for one, this is the largest pure-play defense contractor around the world and they do have a very diverse set of assets that will do them well in time. For the next few years, this is mostly going to be an income-generating story. The good news is, they are going to pay shareholders well for their patients, $15 billion in free cash flow coming off next couple of years and they have a three percent plus dividend yield, which should be, I'm not worried about at all. They say that they will probably buyback six billion in shares in the next year plus, that's seven percent of the float at today's prices. They are aggressively going to try to be an incomplete next few years. As you said, looking to the second half of this decade, they have three classified programs they expect to move into production between now and 2026. One of them, I think is a new Air Force fighter, it's not going to be as big programs, the F-35, but that is a massive program. At least three hypersonic production contracts are supposed to, should happen by then, again, these are the missiles five times the speed of sound. This is an area where the Pentagon has convinced they trail China and which is going to get a lot of attention. A couple of years ago, the Pentagon justified the money that was heading to Lockheed, basically saying, nobody has this area of expertise. They are at the forefront there. Raytheon's caught up some, but this is a sweet spot that they have in an area that's Pentagon priority. You add to it, they have to multibillion-dollar helicopter bake-offs right now for the army, they're going up against Textron in both. I think Textron wins at least one of them to be honest, but I think Lockheed, with a very weird experimental design, if it proves out they will win the other, there's missile-defense, there's an air force tanker competition. Even without these pendings, they have a lot of that is baked in that will hit production in the second half of this decade that will do them very well if they get any of these other rewards for their competitive right now, there's a lot of growth there. It's just, again, for next couple of years, this is an income play and they basically just came clean with new management saying, look, we're not doing a lot of growing this year and next. We'll try and keep you at bay with cash return, but you're just going to have to wait for us.

Nick Sciple: When you look at, obviously, very aggressive with those buyback plans, [laughs] over five percent of the float potentially getting taken out. What do you make of that capital allocation decision given the valuation of the company today and what we just laid out as far as potential opportunities going forward? They just constrain on how they can deploy that capital because of the nature of their business?

Lou Whiteman: In a way, it's the opposite where a lot of their R&D is paid for by the customer. It then that's part of what we're seeing now. A lot of the revenue they're getting right now are these contracts that we hope will be in production later. I don't mind that. This is a very well-capitalized company. Part of what happened in this quarter is that they are adjusting the way they do pensions, taking some of the pension off of the books. Defense isn't supposed to be a tech like growth story. A lot of it is reoccurring revenue income. Yes, they are putting the foot to the gas pedal right now because they need to appease shareholders. But let's be honest, they're having enough trouble with this Aerojet deal. They can't really realistically say we're going to deploy six, seven billion dollars for acquisitions right now if they have to. It seems like a sensible move. As a current shareholder, I am not going to complain about that given they don't see a lot of growth on the horizon.

Nick Sciple: You mentioned that Aerojet Rocketdyne deal, Lockheed Martin getting involved more fully in the space industry and other defense company involved in space, Northrop  Grumman and reported earnings this morning down some but not quite as negative reaction from the market as we saw to Lockheed.

Lou Whiteman: Very similar results, but a much less pessimistic talent should we say, until you have the stock is down some but not as much. They also beat 663 compared to 599 with the estimate, I think. But they again missed on revenue not by as much, only by a couple $100 million. They did slightly raised full-year earnings estimate and kept revenue steady. They say, they believe they will see, "continued organic sales growth into 2022," which is much different than what Lockheed said. As you said, a lot of that is fueled by space on Northrop has four segments. They report. Three of them saw revenue fall. Space was the exception. Northrop in a way in space has a couple of years ahead of Lockheed Martin. They bought a company called Orbital ATK a few years ago. Aerojet is basically Orbital's biggest competition. Both companies today have a space offering. Northrop's is much better rounded out and it appears for now space is the growth area for defense hardware and Northrop with the better exposure there. They're going to do at least less bad if not better than Lockheed. The other interesting, I think from Northrop of this morning and again, they just did release this morning, so we haven't really dug into it. But on the call, CEO Kathy Warden and said they are hiring in anticipation of workers quitting over the vaccine mandate. As a government contractor, they have to have their employees mandate vaccine. I believe it's by December 8th. She didn't have clear numbers on percentage of vaccinate. But again, if you talk about the uncertainty and what's driving some of these tepid guidance is, that's just another thing hanging out there that they are trying to plan for, but really, they can't. It's just a weird moment, I think, for the sector.

Nick Sciple: I think that's testament as a government contractor may be subject to a little bit more restrictions and regulation than you'd see from typical companies. This is just one example. You talked about the optimism around space. Is this just the space force coming into its own? Is this the big deal of where we're seeing for future investment in the military?

Lou Whiteman: Well, yeah, to some extent, but we know some of what's going on here with Northrop. They won a huge contract. It could be upwards of $100 billion by all set has done to replace the 1960 era is Minuteman rockets are ICBMs. That's a lot of this is the initial funding into that. They also said classified space, so that is what is actually being put up there. A lot of that is probably claimed us dine spy versus spy communication stuff, things like that. But who knows? Space is definitely, again, if you think of great power conflict, there's probably a lot more concerned right now from the Pentagon that we need to win space than there is. We need a new-generation of say, a tank. I think it's a natural logical thing to see the emphasis on the domains where we're most worried and definitely space rocket, missile-defense. That's where it is. Much more so than some of the, I guess, World War II vintage, what you think of with defense.

Nick Sciple: Maybe moving onto the third company here, Boeing. Boeing also involved in space like its commercial business, plagued by some issues.

Lou Whiteman: Yeah, and of course, Boeing is both a massive defense contractor and defense sometimes can be an afterthought with them, especially in the last few years with the drama they've had and that continued. We mentioned, I think maybe Lockheed Martin was doing some housecleaning. Certainly, Boeing is still in the process of getting out from under the 737 Max issues that was grounded for what, 18 months while they work through issues there. They had the COVID issue which hit on demand and now the 787 Dreamliner is in a state of perpetual fix right now. So we knew it was going to be ugly and sure enough, they lost 0.60. That's much worse than to 20 cent consensus. Some of that was just new charges that the analysts didn't know what to do, so I don't think that the numbers is nearly as bad as the headline. They also, again, a slight miss on revenue and again, keeping with that theme, it's a complicated supply chain right now. I mentioned the bigger unexpected loss, that's part of that is another one billion dollars charges related to the Dreamliner. This is their composite plastic plane where they are still trying to figure out some of the joints and fatigue. It's not fatal to the program, but it is taking stubbornly long. Let's face it after the 737 Max, Boeing right now isn't getting the benefit of the doubt with safety regulators, so they are going slow as they should. There were some really good news, or at least green shoots in their free cash flow, which was a real albatross on this company last couple of years. It beat expectations. It's still an outlay, they're not bringing money in, but they used about 500 million versus 800 million, expected. Net debt is stable, mind you, it's 42 billion and was less than 10 billion just a few years ago. The emphasis here is that they're beginning to get there, but there's still a long ways off. This is a company that has $367 billion of orders on the backlog, it's still got great potential, but we're just seeing it's going to take a long time to get there. This quarter was another reminder of yes, it is still very much the patient is on the operating table, we're not into post-op yet.

Nick Sciple: It seems like every quarter, we pull another couple of $100 million of charges that out of the mattress. We've had you on the podcast quarter after quarter talking about what's going on here and the question is always been when do they turn the corner? Still waiting.

Lou Whiteman: Yeah. If you look at some of the individual programs because there's a lot to this company. As I mentioned, the 787 is right now, the problem trial that's running at two frames per month and that's well under. Even with COVID, they've been hoping to have five frames coming out of month. They hope to get back there as soon as possible, but it's not going to be immediately. The 737, which is 19 per month, they are very ambitious here, they are raising that to 31 frames a month in 2022. That really spend will speak to what they see us demand in the second. But it is worth noting that pre-COVID, pre the 737 MAX issue, this was going to be the greatest plane in their history because they were going to be at 50 or 60 frames per month. Even if they get to this ambitious 31 in 2022, we're still not anywhere near where we were. They also they kept producing some 37 MAXs when it was grounded. They have an inventory of maybe 370 planes sitting on their lots that they have not delivered yet. They believe they can reduce that by 50 percent by the end of 2022, which would be a great fee. If you look at that plus the production planes that they have, they are saying they're going to deliver 400, 450-plus of these planes in 2022 compared to well, less than 300 this year. Definitely, again, we have to look out into the future, but they are making progress. Over on defense, it is a big defense business against space, was the headliner for all the wrong reasons. There's Starliner capsule, which is competing with Elon Musk's SpaceX Dragon, to shuttle astronauts between the earth and the space station. The Dragon has done very well for SpaceX, Starliner still hasn't been able to do a test launch, they did a lot of charges over there. That's really holding defensive defense margins back. But overall, defense is a lot more steady than it was. But we've learned over the years, that right now Boeing's commercial is what moves the needle. It's off of its lows, but we're on a path to recovery, it's a slow path and investors shouldn't underestimate just how long that will take.

Nick Sciple: What would management or Boeing have to do to get your trust back at this point?

Lou Whiteman: I think it's a show-me story, they have a lot of ambitious plans for how things will get back. But first of all, they need to get these planes in the air. Whether it's the 787, we didn't even talk about the new triple 7X, the new version of their largest plane which is going to be now almost three years behind schedule. Again, the good news is the FAA, which took some justified criticism during the 737 MAX issue, there a lot harder on Boeing now today than they are, and that's for every one is good. But I think they deserve to be in the penalty box right now, and really, we know the potentials there, they have duopoly with Airbus. There's great long-term demand for airplanes, if you look at the emerging markets around the world, travel is only going to increase over the next 20-30 years. It should be a good stable stock, but first, we have to figure out for sure that they can reliably deliver on their promises. They've set some really ambitious goals, let's talk again in a year and see how those are going. If it's smooth flying from there then maybe this becomes interesting again.

Nick Sciple: We'll see what happens with Boeing, it's awaiting for good old story, we'll see if he ever shows up. You mentioned Boeing has had some of these issues with their commercial airplanes hoping to reaccelerate deliveries next year in 2022. One of the trends we've talked about or are heard about somewhat in the market is that, with issues in 2020, we've seen a spike up in demand for our private airplanes, which ties in to the company we're going to talk about last here, which is General Dynamics. They own Gulfstream, which is just private jet producer and they are seeing their largest backlog and they've seen in a number of years.

Lou Whiteman: Let's give a little context here. The private jet, the business jet business really never recovered from the 2008-2009 recession for a lot of reasons. For one, if you remember the time, I think consumer advocate Elizabeth Warren was really hitting on companies for their jet fleets and so as we saw a delay there and then simply just a rearranging of priorities for corporations. But the business jet market has really been hit hard. We've been saying for a while, we think that should trend back as the fleet ages as post COVID people maybe don't want to go through the airport experience as much. As companies like Wheels Up in some of these that begin to bring small jets to the masses. But General Dynamics has been an underperformer for most of the last decade compared to Lockheed and Northrop because of Gulfstream, it's finally beginning to pay off. They also beat on earnings, 307 versus 298 expected. Again, another slight miss on revenue which if we get the theme there. The revenue weakness though was mostly defense, they said supply chain, they called out chips specifically. The good news is defense margins and this is mostly shipbuilding, although they do have land systems and some other things and defense IT, which will get to in a second. Defense margins came in higher than expected and a relatively robust 8.7 percent, which for government contractor looks pretty good. But the story was all about Gulfstream. Sales were up five percent, our operating margins were up. We just went through a big product renewal with G800 and a few of these planes that finally the R&D is moving off and we're going to get to the profitable, strong margin side of the business. Their book-to-bill was 1.7 times, that means they booked 1.70 for every dollar they build out. That's a great sign of the future. Textron who Cessna business, they were at 1.6. So this is the industry's coming back. Over the last 10 years, third-quarter, their book-to-bill has been under one, so that's just an idea of where we are right here. Free cash flow was stronger than expected. Just across the board. We're now looking to a period where if nothing goes wrong, Gulfstream should drive earnings for the rest of this year, even as far out as 2023. This should give them a real leg off to at least close that long-term valuation gap against their peers. If not, I'd say maybe exceed them if Gulfstream really gets up and running.

Nick Sciple: When you look at General Dynamics, it's fair to say you've got some growth potential in Gulfstream, this business, jet business laying on top of really stable naval submarine, that sort of business, that just isn't going to go away. I think they are one of the only companies that makes the submarines that they produce.

Lou Whiteman: They and Huntington Ingalls are the two big shipping and contractors and yet they split a lot of the submarines. They have the Virginia class, the nuclear submarines. The other thing that really makes General Dynamics stand apart too, because they don't have this huge airplane business or some of these businesses that have gotten Lockheed Northrop done well. But General Dynamics went against the industry a few years ago. When most of the industry sold their IT assets. Generally, dynamics doubled down, they did a big deal, they are the second largest government IT provider out there. This is a part of the industry that I think it's going to hold up a lot better. Sure enough, their book-to-bill on defense side, IT was the standout, at 1.10 per dollar bill. That's where you want to be right now, not these platforms in the next year or so. You couple Gulfstream with their IT business, I think, clearly, this is the top big defense prime stock to look at, I think as far as next 18-24 months.

Nick Sciple: Among this group of Boeing, Northrop, Lockheed Martin, you'd put General Dynamics top of that list because of these other growth opportunities they have.

Lou Whiteman: Right. Definitely for the next few years. I think IT is very much an under-appreciated story. Just this week, we saw a small government services company taken out at a 70 percent premium by a private equity. That's just one little company and it's much smaller than these guys. But I think that's an idea of there is a real disconnect between public market perception right now and what the "Smart money", thinks for the sector right now. I don't think private equity is wrong, I think for at least the next few years, General Dynamics will be very glad that they zigged when everyone else zagged, and they have that plus Gulfstream. It's finally looks like they're moment to shine.

Nick Sciple: Lou, to close out, I wanted to ask you about maybe a big trend folks should be paying attention to. Obviously, we opened up talking about things that have happened in Afghanistan. This push toward great power conflict. As you look out forward, is this IT business really the place you have your sights set on?

Lou Whiteman: Yes, I'd say don't sleep on that. If you look at it without going too far into the weeds, but the White House is requesting over $100 billion in a fiscal 22 for government services, all governmentwide, that's a 7.5 percent jump over actual spending in 2021. That is growth, that includes civil agencies, that includes the Pentagon, that includes Top Secret. But the other big part of this that I don't think is fully appreciated is 83 percent of that government IT spending goes to the contractors. That is much different. When people hear that 700 billion number for the Pentagon, remember, a lot of that is payroll, a lot of that is buildings. That's not 700 billion for the contractors. But in a tight budget environment, the Pentagon quite obviously is not going to outsource fighter pilots. There's only so many areas they can cut costs. One area where the government can cut cost is to outsource everything from the Top Secret stuff to just the Commerce Department's email. You are going to see that in a tight budget environment, this is where the government looks, that's very strong for defense IT. You couple into the fact that last time they ignored this area and they ran into all sorts of problems with the Edward Snowdens of the world. I'm very confident that defense IT is going to hold up a lot better in the market. That's good for General Dynamics. I think Nick, we've talked about some of these companies before. There's Leidos Holdings, Booz Allen Hamilton, ManTech. I just think these companies are much better set up to perform for investors in the next 18 months to two years than these defense primes that are making hardware.

Nick Sciple: Great stuff, Lou. Yeah, I would say for folks if you're interested in hearing more about this space, definitely look back into some of our previous podcast we've done over the years and over the past few months to get some more detail on this defense IT sector. Lou, until next time, thank you for joining me. Always love talking to you.

Lou Whiteman: Great to be here, Nick. Thanks for having me.

Nick Sciple: As always, people on 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 Rick Engdahl 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.