Thursday, August 8, 2013

Point/Counterpoint: Bernstein Very Bullish On Defense Stocks

I posted a note yesterday describing the negative outlook for defense stocks from that Merrill Lynch's Ron Epstein.

As I wrote, Ron believes that investors are blithely ignoring the poor fundamentals for the group.  With the war in Afghanistan winding down, and large pressure for action on reducing the budget deficit, defense spending seems poised to crater in the coming years.

Yet the stocks have continued to move sharply higher, far outpacing the gains of the S&P 500 year-to-date.

As luck would have it, Bernstein's defense analyst Doug Harned was in town today, so I went to hear if he agreed with Espstein's views.

Not in the least, it turns out.

Doug is bullish on the group even after the strong run this year.  Yes, he is very aware that spending on defense is likely to move sideways or lower in the coming years.  Yet he thinks the stocks have only begun to move higher because of their business model.

Harned pointed out that defense stocks can outperform the market significantly even if the defense budget is being cut. His empirical work suggests if the free cash flow (FCF) of the companies is much higher than the overall market, the stocks will work very well.

Defense stocks today have FCF yields that are 6-7% higher than the S&P, and company managements have signaled their willingness to return cash to shareholders either in the form of higher dividends or share buybacks.  Northrup Grumman, for example, has said that it plans to buy 25% of its outstanding shares back by the end of 2014.

Here is a slide from his marketing deck supporting his views on the stocks:

 

The business model of the defense industry makes them more "bullet proof" (pardon the pun) to the overall business cycle than other industrial companies.  If the military wants Lockheed Martin to make a change in the F-35 program, Lockheed will say fine - pay for it.  On the other hand, if Boeing has a problem, the cash to make it right has to come from the company coffers.

There has been a major consolidation of the defense industry over the past few decades.  While this can bring cost synergies to company operations, it also means that there are fewer options for the military to get better pricing.  Our U.S. military is reluctant to rely on foreign supplier for equipment for obvious reasons, which puts the U.S. manufacturers in an excellent spot to push back on any demands for price reductions.

The valuations of the defense stocks is very attractive even after their recent run.  According to Harned's work, the 67% EV/EBITAP is in the 23rd historic percentile.  In 9 of the 13 years where stocks were trading below 65%, defense stocks rose the next year - including 3 years when the defense budget and margins declined:

 





Finally, Harned pointed out this surprising fact:  despite their stodgy image, and the supposed cyclical nature of their business, have been terrific performers over the past few years:

 

I liked Harned's presentation, and his willingness to take a contrarian view from most other defense analysts who tend to agree with Ron Epstein.