Defense Stocks Continue Dropping

Shares of the country’s leading defense companies have been fairly weak in recent weeks as worries of budget cuts in the U.S. defense budget have surfaced. It’s true that the Pentagon has actually asked the government to not fund certain projects that it deems unneeded. However, not all defense companies will see a reduction in spending growth.

Most of the cuts will likely center around missile defense systems and certain models of fighter jets. Other areas of the defense sector, such as homeland security, intelligence, and surveillance equipment based on new technologies, should continue to thrive.

One of the leaders in this area is L3 Communications (LLL). Along with the rest of the sector, LLL shares have dropped in recent months, and now trade under $74 per share, about $11 below their 52-week high.

L3 is trading at a market multiple of 15 times earnings, despite above-average growth for the defense industry. CEO Frank Lanza continues to make small, strategic acquisitions to fill out the company’s new product offerings, and the L3’s solid performance should be able to weather any small cuts in less important areas of the U.S. defense budget.

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11 Thoughts on “Defense Stocks Continue Dropping

  1. Jack Miller on November 22, 2005 at 11:28 AM said:

    The problem, as I see it, can be illustrated by looking at Boeing. Boeing makes its serious money in the expansion phase of the economic cycle selling commercial aircraft. However, the company is half defense contractor and half commercial aircraft company. Like all major sectors there is a see and saw. Restaurants perform at about the opposite time as grocery stores; drug stocks perform when health care providers stop. Boeing is on a run because the commercial side is kicking-in but the defense side has already had its day. The government will work toward a balanced budget from now until the next big recession, and then the government will buy two of everything. Until then, I will avoid the defense sector.

  2. Chad Brand on November 22, 2005 at 4:34 PM said:

    Keep in mind that 75% of Boeing’s earnings come from the defense business, not commercial aircraft. And while aircraft earnings have risen 20% during the first nine months of this year, earnings from defense have risen by 30%.

  3. Jack Miller on November 23, 2005 at 5:31 PM said:

    Yes, the current earnings come from defense; which is exactly my point. One should never buy a stock based on current earnings. Peak earnings will fool you everytime and the best buys I have ever made were companies that were making no money at the time I purchased.

    The key to success in the market is to buy what is going to have strong future earnings. In Boeing’s case, the new plane orders are already on the books. The stream of earnings from commercial aircraft are just starting. I don’t know Boeing’s accounting rules but I suspect the earnings are booked on some kind of % of completion rather than when the order is taken or completed. The profits from plane sales are spread over a long period of time because the parts orders continue for many years to come.

    I read your blog regularly because you are “on the money”. In this case, I believe defense issues will underperform over the next several years.

  4. Chad Brand on November 24, 2005 at 9:04 AM said:

    In L3’s case, I think you will be surprised how well they perform in coming years. As I mentioned, they won’t have the same types of headwinds that others like LMT might have if budgets are cut meaningfully.

    As for Boeing, the new plane orders will have to be awfully dramatic to make a meaningful impact. Even a 25% jump in aircraft volume will add less than 10% to BA’s bottomline given that defense is such a smaller portion of their business.

  5. NO DooDahs on November 25, 2005 at 10:16 PM said:

    Yep, they book the revenue on a smoothed basis, which of course gives them more room for shenanigans, all the more reason to go over their books with a fine tooth comb.

    LLL has a few warning signs on their financials. Note the free cash flow is persistently negative. Gross margin YTD 2005 is below 2004, which was below 2003. The company’s equity would be negative if the intangibles were removed. YTD 2005 Acct Rec’l as a percent of revenue are the highest since 2001. The company relies on cash flow from financing in order to book earnings, not a year in the last five has gone by without a net issuance of debt and capital stock. Interest expense appears to be growing exponentially. Did you see the long-term debt double in 2005? And what’s with the growth of “other current liabilities?”

    First note on BA is EIGHT different insiders selling about SEVEN MILLION in shares in the last month, all at about $65 per. That’s eight guys who should be in the know, thinking they’ve got other, better, places than BA to put their money. Per MSNMoney, BA is more expensive than its industry for PE, PB, PS, and PCF. BA’s buildup of inventory as a percent of revenue is now the highest it’s been in the last five years – inventory buildups often precede earnings misses or warnings. Not the best set of financials I’ve looked at, but not pathetic like LLL’s.

    I haven’t looked at the technicals or the proxy statements, but based soley on the fundamentals I would rule out investing in either of these companies.

  6. Chad Brand on November 25, 2005 at 11:00 PM said:

    I’ll respond for LLL and let Jack do the same for Boeing, if he would like.

    First off, free cash flow at LLL is NOT negative, as “no doodahs” suggested. FCF in ’05 will come in between $600M and $625M. FCF for next year is projected at $725M.

    While it’s true that gross margin has been falling, net income has been rising. The goal of acquisitive companies (as followers of LLL know) is to cut costs and therefore have a deal be accretive to earnings. If a deal allows you to dramatically increase earnings by cutting costs, you can justify buying a company with lower gross margins that you, so long as the deal is accretive to shareholders.

    LLL’s acquisitions also explain the increase in debt and goodwill on the balance sheet. Debt is used to fund the purchase, and free cash flow is used to delever the balance sheet after the deal closes.

    The doubling of LLL’s debt from $2B to $4B this year is due to their $2B purchase of Titan. One must follow what the company has been doing to understand the financial statements. Merely saying the fact that debt jumped $2B doesn’t, by itself, imply the balance sheet is “pathetic” and the stock will be a dog.

    In the end, earnings drive stock prices. As a result, it’s no surprise that LLL stock has risen 60% in the last two years, as earnings will hit nearly $5 in 2006, up from $3.36 in 2004.

    Boeing has done even better, rising 70% in the last 24 months, as EPS was $2.31 in 2004 and is expected to be more than 40% higher in 2006.

  7. NO DooDahs on November 26, 2005 at 8:42 AM said:

    Whoops! I forgot something! Neither of these make a compelling short IMO, or a compelling long, so I won’t have money on this one. Per the Whole Foods comments, I hold the vast majority of stocks as “don’t touch” and these fit that category.

    I thought that Jack was negative on BA from his comment, so I wouldn’t expect him to defend it as a long proposition. BA looks better than LLL to me, but still a “don’t touch” from valuation standpoint.

    I am curious what both of you think about the cluster of insider sales at BA. I rarely see so many insiders selling in such a short period at such high volumes. I mean, eight guys selling seven million in one month? Have you checked the proxies, is there a good explanation for that, like tax selling?

  8. NO DooDahs on November 26, 2005 at 8:34 AM said:

    Serial acquirers often fall flat on their face, habitually growing through acquisition is usually a sign that management is incapable of creating organic growth. This shows on the balance sheet as a high percentage of assets being “intangible.”

    The above suggest that FCF was briefly and barely positive in 2004, negative in 2000-2003, and that LLL would have to generate about $3 billion in positive FCF in the fourth quarter in order to hit the black this year. If you have a different source for the FCF calculation, please share it, I may want to use it when examining other stocks.

    We’ve had disagreements about “projections” before. Basically, I like to see tangible results and positive trends on the actual posted results, with absolutely no signs of poor earnings quality. LLL is rife with signs of poor earnings quality.

    You argue that share price appreciation due to increased earnings per share is accretive, and I agree in principle. Where I disagree is that I don’t see the earnings of LLL as being of high quality, therefore I hold their future prospects suspect. In terms of tangible book value, they have been a destroyer of capital. The lack of FCF suggests they have no ability to return cash to shareholders (again, I’ve posted a source for the FCF calculation, feel free to post a different one). I wouldn’t call a dividend yield of less than 1% accretive.

    Stock price outperformance in the last two years isn’t necessarily indicative of future outperformance.

    For me, the purpose of having comments on my blog, or making comments on other people’s blogs, is primarily to discuss pros and cons of positions taken. I see this as a Socratic method of sharpening my own analyses. While often when I make a comment it’s because I disagree with the original post, that doesn’t do justice to the fact that I do learn alot from reading your blog and others.

  9. Chad Brand on November 26, 2005 at 10:55 AM said:

    While there have been many serial acquirers that have failed, I think it’s unreasonable to assume LLL will simply for that reason. The defense industry is highly fragmented, with a few very large players and thousands of small companies with good products that havea tough time getting exposure. LLL’s strategy has been to acquire these smaller companies in order to keep their product lines fresh with the latest technology. So, there is a reason LLL does this, and a reason why they’ve been wildly successful.

    Does that mean they will continue to be wildly successful? Of course not. I never implied the stock would go up in the future just because it has done well in the past. I was simply showing that the strategy does work and there is a reason behind it.

    If you avoid all serial acquirers, that’s fine. They will always have a lack of net tangible assets due to tons of goodwill on their balance sheet. LLL’s organic growth rate would be lower if they did not buy these businesses. They target 8-10% organic growth, but have grown much faster than that in the last five years due to acquisitions.

    As for your free cash flow statistics, I do have to take issue with them. I guess MSN uses the wrong formula for free cash flow. Free cash flow, as I’m sure you know and simply assumed MSN’s numbers were correct, is defined as net cash flow from operations, less net capital expenditures.

    LLL’s free cash flow was $194M in Q3 2005 and $511M for Q1-Q3 2005, per LLL’s own Q3 financial release. As I mentioned, FY 2005 should be around $625M, with FY 2006 around $725M. And yes, these are estimates, and yes, we can’t be absolutely sure they will materialize, but that’s an obvious point and need not be made.

    Your main point I think, and the one that is the strongest argument against LLL, is the fact that much of their growth comes from acquisition. While you consider this to be poor earnings quality, they do have the cash flow to show for it. Some companies don’t have free cash flow and will simply do things to hit their EPS number to avoid a Wall Street meltdown.

    LLL does have tons of free cash flow. It does only pay a 0.7% dividend, versus the industry that pays 1.5% to 2.0%, but again that plays into what their strategy is. They use the free cash to buy companies and pay back any money they borrowed to fund the acquisition.

    Finally, I certainly don’t mind comment posters, such as yourself, who post the pros and cons of positions. As you suggest, the discussion is one of the reasons I allow comments in the first place.

    However, it is clear we have very different methods to picking stocks. You are a lot more conservative than I am, as seen by the fact that you argue against my long ideas. Maybe when you agree you remain silent, and only post when you disagree, but at any rate, most of your posts are negative. Nonetheless, I appreciate your time to post, as it sharpens my skills as well. Maybe at some point, we’ll even agree! 🙂

  10. NO DooDahs on November 26, 2005 at 11:42 AM said:


    It’s a bad habit on my part, commenting mostly when I disagree. I’ll try to work on that and comment on the ideas I like as well. Sorry! As an example, we’re both energy bulls at these prices and I’m long CVX and COP, based on a previous post I would assume you are as well. We’re both bearish on TIVO, think sell-side analysts are born (or at least paid) liars, AMZN is overpriced, and the real estate bubble is bursting. So there is significant sphere of agreement between us, and I will try to reflect that in my future commenting habits.

    Would you mind if I put a link to your blog on my own (recently started) blog?

    I am fanatically picky about ruling out investment ideas, but being an individual investor, I only need about 1-2 dozen positions to pay off, don’t have to worry about lots of the institutional concerns, etc. “Conservative” may not be the 100% right word for it, because I take unhedged long and/or short positions, and buy as soon as I identify targets without trying to time the entry, don’t use stop losses, etc. Another difference I’ve ID’ed between us is that you tend to focus more on the macro elements, where I generally don’t – I view myself as buying parts of companies and not placing positions in segments.

    Acquisition and poor earnings quality metrics are my arguments, there are some signs of poor earnings quality aside from the acquisitions and FCF, namely:
    “YTD 2005 Acct Rec’l as a percent of revenue are the highest since 2001. The company relies on cash flow from financing in order to book earnings, not a year in the last five has gone by without a net issuance of debt and capital stock.”

    Regarding FCF, there are a plethora of “accepted” definitions.
    {Some analysts refer to free cash flow (FCF) as a basis for measuring a company’s ability to meet continuing capital requirements. Others argue that FCF should represent the cash available after meeting all current commitments, that is, required payments made to continue operations (including dividends, current debt repayment, and regular capital reinvestment to maintain current operating activities). Still others argue that FCF should represent the cash available after meeting operating expenses, including working capital additions and the cost of maintaining operating assets. This approach defines FCF as “CFO minus capital maintenance expenditures.” International Accounting Standard (IAS) 7 recommends that FCF should be recognized as “cash from operations less the amount of capital expenditures required to maintain the firm’s present productive capacity.” Using this description, dividends and mandatory debt payments would not be subtracted to arrive at FCF. Thus, using this description, discretionary cash expenditures would include growth-oriented capital expenditures and acquisitions, debt reduction, dividends, and stock repurchases.

    IAS 7 implies a capital maintenance approach; that is, capital expenditures should only represent those expenditures necessary to maintain the company’s operational assets. Expenditures beyond this amount should represent discretionary expenditures. To compensate for the lack of normal capital expenditure information, many analysts use total capital expenditures, thus generally understating FCF.

    Some regulatory agencies use FCF as a measuring tool. These agencies use a percentage of sales or assets to represent a surrogate capital maintenance expenditure amount. The New Jersey Gaming Commission, for example, uses FCF in its financial viability analysis and defines capital maintenance as “five percent of net revenues.”}

    Click the link for sidebar #2 at the bottom of the page for discussion of some of the inconsistencies in application of FCF definition.

    Regardless of exactly how you define it, the concept of leftover cash once capx is accounted for is useful to determine if the company is or can generate cash to be used for business expansion …

    Maybe the MSN site has a mistake on the calculation for LLL. I have found mistakes on their stuff before. Maybe they just use a different formula than LLL does in their own release. Their bread would be buttered to pick a formula that put them in the best light, don’t you think? To my knowledge there isn’t any consistent application of FCF formulation that I’ve found, so for ease of application I use the MSN calculation, although since I download every company into my own spreadsheet, I could probably test multiple formulae for this. Of course, if there were an actual mistake on their feed, using my own formula wouldn’t fix the problem.

  11. Chad Brand on November 26, 2005 at 1:05 PM said:

    Don’t feel obligated to post your agreements if you prefer, and get more value from, focusing on playing devil’s advocate. I’m glad to hear we do agree sometimes. I think our contrarian bullish energy positions will do very well.

    Feel free to link to my blog, and I’ll check yours out.

    Perhaps very selective, not conservative, would be the better characterization. I meant very careful in what you put in your portfolio and the criteria you use, as I saw from your “6 things to look for in a short candidate.” Finding most or all of those is probably not as easy task, but rewarding when you do find a match. I may only focus on a couple of the six, which could also be profitable as well.

    I can definitely tell you focus not on the macro environment, but rather mainly the financial statements. My ideal investment combines a bullish macro position, with a cheap valuation. However, for many of the reasons you mentioned, I don’t limit myself to just those criteria, even though doing so would produce a very profitable portfolio. Since there are a lot of reasons stocks do well, I stick my feet in many different waters. However, when I do find the sacred combination, I focus on them. I think the oil stocks present this type of rare opportunity, a bullish macro outlook and single digit P/E’s. The valuations are low because people are betting that we’re seeing peak earnings, but I disagree. Quite the payoff if we’re right.

    As for FCF, I use the CFO less CapEx definition. I just took those numbers from the L3 financial statements. I was curious, though, how they define it internally. From their Q3 release, here is one of their footnotes:

    “Free cash flow is defined as net cash from operating activities less net capital expenditures (capital expenditures less cash proceeds from dispositions of property, plant and equipment). Free cash flow represents cash generated after paying for interest on borrowings, income taxes, capital expenditures and changes in working capital, but before repaying principal amount of outstanding debt, paying cash dividends on common stock and investing cash to acquire businesses and making other strategic investments.”

    While some may disagree, I do think this is a very reasonable definition, so I’m not alarmed.

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