There are quite a few defense contractors showing up in the Gurufocus Value Screens. Lockheed Martin (LMT) and General Dynamics (GD) have been on the Buffett-Munger Bargain screener for months. The Undervalued Predictables screener has them too, as well as Harris (HRS), Rockwell Collins (COL) and United Technologies (UTX).
Most of these companies are trading at high single digit P/E ratios (with the exception of UTX which is a more diversified company) and sport generous dividend yields. But with the previously announced defense budget cuts, projected slow top line growth in the annual defense budget, and the possibility of more cuts looming from the Congressional Debt Super Committee are these companies really value traps? We think they aren’t. To find out why, we need to look at the Department of Defense (“DoD”) budget.
Parsing the DoD Budget
The DoD budget is made up of two components. The first is the base budget and the second is the OCO or Overseas Contingency Operations budget which includes funding for the war in Afghanistan, Iraq, and various other overseas operations such as Somalia and Pakistan. The base budget is split in to seven categories; military personnel, operations and maintenance (also called O&M), procurement, RDT&E (that is research, design, testing, and evaluation), military construction, family housing, and revolving and management funds. Major defense contractors have a majority of their revenue exposure to changes in the procurement and RDT&E line items and some exposure to the operations and maintenance account.
The table below shows the changes from the DoD FY2011 budget to the FY2012 request.
We see increases in procurement which would represent continuing purchases of mature weapons systems but reductions in RDT&E which would represent less money spent on development of new weapons system. This is commensurate with the DoD stated goals of continuing to upgrade the militaries equipment but cutting back on new (and usually exotic and expensive) weapons system development. We also see a large increase in the O&M account, however, only a small portion of this spending finds its way to contractors compared to the procurement and RDT&E accounts.
Former Secretary of Defense Robert Gates announced a $178B reduction in DoD spending through FY2016 with $100B of the $178B redirected in to other DoD programs. At first glance it would seem this reduction would certainly have a large impact on defense contractors, especially those producing the major weapons systems. Therefore, it’s important to examine where the DoD’s cost savings measures come from. Only $10B of that $78B came from reductions that are likely to have a large impact on contractors. The vast majority, $54B, comes from DoD staffing reductions and organizational and operating changes. The next $14B comes from everyone’s favorite tool for meeting budget projections; adjustments to economic assumptions. Finally, $4B comes from adjustments to the Joint Strike Fighter (JSF) program and $6B from reducing the size of the DoD’s ground forces (which will likely impact contractors because of the corresponding reduction in equipment needs).
The $100B in savings that are to be reinvested comes from the following categories.
Just like the first $78B, most of the savings are from reorganizations and staffing reductions with only about 30% coming from reductions or cancelations of major programs. The DoD FY2012 budget request also highlights several specific large scale programs to be cut that are listed below, organized in terms of their impact to traditional, weapons system focused defense contractors such as GD or LMT.
Minimal Impact to Major Contractors ($24.7B)
Reduce infrastructure civilian and military manning ($1.1B)
Save on military construction costs by sustaining existing facilities ($1.5B)
Consolidate e-mail infrastructure and data centers ($.5B)
Reduce recruiting and retention incentives and other manning initiatives ($6.7B)
Reduce ashore manpower, reassign personnel to operation ships and air units ($4.9B)
Disestablish Second Fleet HQ ($1.0B)
Reduce energy consumption ($2.3B)
Reorganize Air Force ($4.2B)
Reduce fuel and energy consumption within AFMC ($.7B)
Reduce Air Force facility sustainment ($1.4B)
Consolidate SOCOM task orders ($.4B)
Medium Impact to Major Contractors ($8.3B)
Increase use of multiyear procurement contracts for ships and aircraft ($4.0B) (we are assuming this will have some impact as contractors are made to adhere to stricter performance targets)
Improve depot and supply chain business processes ($3.0B) (we are assuming this is code for reducing the margins of suppliers)
Reduce cost of communications infrastructure by 25% ($1.3B)
High Impact to Major Contractors ($11.7B)
Cancel procurement of SLAMRAAM ($1.0B)
Cancel N-LOS System ($3.2B)
Cancel EFV ($2.8B)
Reduce or terminate several Air Force programs ($3.7B)
Terminate Joint Multi-Mission Sub program ($.8B)
Reduce SOCOM specialized equipment ($.2B)
So what does the DoD plan to do with the $100B in savings it gets to reinvest? Well $70B will be invested on high priority projects to enhance the DoD capabilities. Major investments that affect defense contractors include the modernization of Abrams tanks, Bradley fighting vehicles, and Stryker vehicles, acceleration of the fielding of the Army’s new tactical communications network, procurement and development of more Army UAVs, acceleration of the Navy EW capabilities, repair and refurbishment of Marine equipment, develop a new sea-borne UAV, increased procurement of F-18s, the purchase six additional ships, the purchase of more Air Force UAVs, modernization of the F-15 radar, increased procurement of JSF simulators, and the start of a program to develop a new long range nuclear capable bomber. In fact, the only item in the $70B reinvestment plan that likely doesn’t involve a defense contractor is the Army’s new suicide prevention program. All other programs mentioned by the DoD involve the design, purchase, modernization, refit, or refurbishment of weapon and communication systems
So although the top line budget of the DoD from FY2012 to FY2016 shows only modest growth (shown below), major defense contractors will still be seeing new business.
Also, despite a near term drop in RDT&E spending, the DoD is still planning to continue to purchase large weapons systems and continue it expand its network centric warfare focus. The Fiscal 2012 Budget Request details some long term plans from the DoD that include expanding the Navy from 287 ships to 313 ships by FY2020. The Navy also plans to almost double the number of Ballistic Missile Destroyer (“BMD”) capable ships from 23 to 43 by 2018. The Army plans to continue its goal of converting the entire force to Brigade Combat Teams. The Army currently has 56 BCTs and plans to convert the remaining forces to BCTs by 2014 bringing the total to 73. The Army also has a long range plan for re-equipping and upgrading NG units. The Air Force plans to increase its procurement and use of UAV’s including the expansion of UAV coverage from 45 ISR orbits to 65 in 2013. Finally, the entire DoD is only 32% of the way through a large scale upgrade of its communication networks.
Despite the headline risks of reading or hearing about cuts at the DoD a thorough examination of the DoD’s budget shows that most of these cuts are focused on the organization structure and business practices at the DoD and less on reducing weapons system procurement. The biggest risks for investors are that the new Congressional Debt Super Committee forces more large scale cuts on the DoD. We view this as unlikely for several reasons. First, the so called “nuclear option” that goes in to effect if an agreement isn’t reached does not contain any specifics on how the cuts to the DoD are to be enacted. Without any specific mechanism for enacting or enforcing the cuts it is unlikely they will be made. Second, both political parties are targeting other areas, specifically Social Security and Medicare for cuts. Up until recently the DoD had been completely off the table. Finally, spending on the DoD as a percent of GDP is at a low point. Further cuts would do little to meet the committee goals of additional savings.
Disclosure: Long LMT
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About the author:
Ben StrubelPresident and Portfolio Manager of Strubel Investment Management, LLC a value oriented, independent, fee-only Registered Investment Advisor (RIA) based in Lancaster, PA.