These Defense Stocks Face an Uphill Battle

Charles is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The Obama administration on Wednesday signaled its desire to cut defense spending regardless of whether or not the "fiscal cliff" gets resolved before year-end.  During negotiations with House Speaker John Boehner, President Obama offered discretionary spending cuts of $200 billion, split evenly between defense and non-defense programs.  This could turn out to be a best-case scenario for defense firms because if left unresolved, the fiscal cliff will include sequestration that will entail more than $500 billion in automatic defense cuts over the next 10 years.

President Obama's re-election was considered negative for most defense-related companies.  In the seven trading sessions after the general election, defense companies including Northrop Grumman (NYSE: NOC), General Dynamics (NYSE: GD), Lockheed Martin (NYSE: LMT), Raytheon (NYSE: RTN), and United Technologies (NYSE: UTX), among others, saw their stock prices decline by as much as 10%.  Since then, these companies' stock prices have recovered to near-election prices despite the very real threat of reduced defense spending going forward.

<table> <tbody> <tr> <td> <p>Stock</p> </td> <td> <p>Price Nov. 6</p> </td> <td> <p>Price Nov. 15 (%+/-)</p> </td> <td> <p>Price Dec. 18</p> </td> </tr> <tr> <td> <p>General Dynamics</p> </td> <td> <p>$69.26</p> </td> <td> <p>$62.13   (-10.29%)</p> </td> <td> <p>$69.52</p> </td> </tr> <tr> <td> <p>Northrop Grumman</p> </td> <td> <p>$69.88</p> </td> <td> <p>$63.23   (-9.52%)</p> </td> <td> <p>$68.70</p> </td> </tr> <tr> <td> <p>Lockheed Martin</p> </td> <td> <p>$94.87</p> </td> <td> <p>$87.58   (-7.39%)</p> </td> <td> <p>$92.91</p> </td> </tr> <tr> <td> <p>Raytheon</p> </td> <td> <p>$57.34</p> </td> <td> <p>$54.00   (-5.82%)</p> </td> <td> <p>$58.75</p> </td> </tr> <tr> <td> <p>United Technologies</p> </td> <td> <p>$79.97</p> </td> <td> <p>$74.84   (-6.41%)</p> </td> <td> <p>$83.03</p> </td> </tr> </tbody> </table>

Source: Capital IQ

In 2011, 69% of General Dynamics' revenue came from contracts with the U.S. government.  Revenue growth has been a meager 1% over the last two years.  Gross and operating margins have declined 1% year over year, but earnings per share have dropped 7% during the same time period.

Operating cash flow has been steady at 10% for several quarters, but could be much improved. Days sales outstanding has averaged 107 days on a 4-quarter basis and receivables were an unacceptable 117% of revenue over the previous 4 quarters.  Inventory as a percentage of revenue has also crept up to 34% last quarter, with finished goods now representing 13% of inventory -- the highest in three years.  As a result, the cost of goods sold inched up from 81% to 82% year over year. GD has also repurchased shares, reducing float by 24.67 million shares in two years.

Northrop Grumman derives about 90% of its revenue from U.S. Department of Defense (DoD) contracts.  Northrop's revenue has continued to decline year over year, from $7.1 billion two years ago for the quarter ending Sept. 30, to $6.6 billion last year; and $6.3 most recently. 

Northrop's margins have remained steady but operating cash flow has benefited from improved cash management, moving from 8% to 12% margin year over year.  Northrop's $387 million in deferred taxes also helps, but will need to be paid eventually.  Northrop spun off its ship building unit in 2011, and so employee head count dropped from 117,100 to 72,500 latest numbers available.

Northrop has continued an aggressive stock buyback campaign.  Since 2007 the company has repurchased 89.4 million net shares for $6.6 billion.

Lockheed Martin earns about 85% of its revenue from the U.S. government, and revenue has been essentially flat year over year - $47.0 to $47.2 billion. Due to Lockheed's high cost structure, margins are uncomfortably low with the gross margin averaging only 12% and the net profit margin only half that (6%).  Operating cash flow margin has averaged 7%.  Metrics affecting cash flow and working capital are better managed than General Dynamics or Northrop, but inventory as a percentage of revenue has blossomed from 15% to 24% year over year.  Days in inventory has also jumped from 15 to 24 days -- a 60% year over year increase.  Lockheed is also the most leveraged of the three companies reviewed thus far, with a 73% total debt to total capital and $6.374 billion debt on the books.  And sure enough, shares outstanding have declined by 36.2 million shares in two years. 

Raytheon is another defense company with steady margins but declining revenue over the past two years, moving down from $6.3 to $6.1 to $6.0 billion year over year for quarter ending the Sept. 30.  Despite this decline, per share earnings growth has been flat over the same period.  Raytheon's operating cash flow margin has average 8% over the past several quarters, but receivables as a percentage of revenue has averaged 79%.  Raytheon's days sales outstanding are high at 72 days, suggesting relaxed payment terms to the government.  Inventories and payables are under control, however. Raytheon has reduced outstanding shares over the past two years by 34.7 million shares, while long-term debt has doubled to $4.6 billion.

Last but not least, United Technologies is a Dow Jones component stock with a large percentage of revenue coming from U.S. government contracts.  The company seems to have broken the revenue mold of the other companies under consideration, as revenue has risen 6% year over year. UTX's cost structure, however, has been rising slightly faster than revenue, resulting in a 4% year over year earnings drop.  On Dec. 14 the company released revised downward earnings and revenue estimates for 2013 based on its recent acquisition of Goodrich.

The 12% operating cash flow margin trailing 12 months is slightly ahead of its peers, but has declined from $1.96 to $1.64 billion year over year. Receivables are on the rise as are days sales outstanding:

<table> <tbody> <tr> <td> <p>METRIC (UTX)</p> </td> <td> <p>9/30/2012</p> </td> <td> <p>9/30/2011</p> </td> <td> <p>9/30/2010</p> </td> </tr> <tr> <td> <p>Days Sales Outstanding</p> </td> <td> <p>64 days</p> </td> <td> <p>61 days</p> </td> <td> <p>58 days</p> </td> </tr> <tr> <td> <p>A/R as % Revenue</p> </td> <td> <p>71%</p> </td> <td> <p>67%</p> </td> <td> <p>64%</p> </td> </tr> <tr> <td> <p>Days In Inventory</p> </td> <td> <p>87 days</p> </td> <td> <p>76 days</p> </td> <td> <p>80 days</p> </td> </tr> <tr> <td> <p>Inventory as % of Revenue</p> </td> <td> <p>70%</p> </td> <td> <p>61%</p> </td> <td> <p>62%</p> </td> </tr> </tbody> </table>

Source: Capital IQ

Moreover, days in inventory are growing as is inventory as a percentage of revenue.  The company reduced shares outstanding by 6.8 million shares in two years, and long-term debt has increased substantially from $10.1 billion to $23.4 billion in the last two years, representing 52% total debt to total capital, but the Goodrich acquisition had something to do with this.

Summary

These defense stocks all exhibit lackluster revenue growth in the face of likely government cuts in defense spending.  They will face greater pressure going forward to manipulate financial results in order to satisfy shareholders' appetites for stock price appreciation. Despite rather anemic operating cash flow margins, all five companies have resorted to float reduction to prop up earnings and some of them have used debt to do so -- an unsustainable tactic.

 


Allen does not own shares in any of the companies mentioned in this article, and has no intention to acquire shares in these companies within the next 72 hours. Allen earned an M.B.A. in 1995, and bases his analysis on generally available financial statements and reports. Earlier in his career, Allen worked for divisions of General Dynamics and Lockheed Martin.  You can follow him on Twitter @CACodyJr.

blog comments powered by Disqus