Aerospace & Defense: Moving to Risk-On; 3 Reasons Defense Works from Here
(Source: Morgan Stanley; issued Dec 11, 2018)
We remain constructive on Defense stocks post yesterday's move (of up ~4%), especially as we gain clarity on FY20 budgets. The probability of up (not down) DoD spending has increased of late, while valuations are attractive and have less linkage to the macro backdrop. Our top pick here is RTN.

Defense stocks looking attractive on budget, valuation, and defensive nature. Defense stocks have performed poorly, consistent with other Industrial sectors (down ~10% YTD). We attribute this to several factors including talk of FY20 budget declines, "undisciplined" bidding behavior (e.g., Boeing T-X), cash flow headwinds, lack of margin expansion, elevated expectations, and the sell-down of well-owned stocks. In our opinion, the most likely culprits are the first and last factors mentioned.

However, considering that budgets now appear to be on a better track, we believe there are three reasons we should be in “risk-on” mode with the group going forward. They include: 1) Budgets are back on track and point to growth, again; 2) Stocks have de-rated considerably and underperformed other low beta peers; and 3) Defense should do well in a period of economic uncertainty. We discuss each of these in more detail below.

In regard to the stocks, we see a rising tide supported by high correlations, though note a preference for LMT / RTN (both OW) given more diversified domestic / international positioning and / or large program visibility (e.g. F-35). NOC (EW) also stands out from a budget standpoint as it has the most US DoD exposure amongst Primes.

1) Budgets are back on track and point to growth, again. Prior to midterm elections and as recently as last week, the US President was keen on reducing DoD spending with comments of 5% cuts and “crazy” Defense budgets. However, the media has more recently reported that following meetings with congressional leaders and senior DoD officials, there has been a reversal in thinking. In fact, it appears that FY20 budget proposals could be as high as $750B (or ~5% YoY growth vs. FY19) and not the $700M (or ~2% YoY reduction vs. FY19).

Also worth noting is that these swings in spending are likely to come from the modernization account where the Primes derive most of their US revenues, assuming no change to Personnel and O&M, and would thus swing from roughly down ~10% to up ~10%. In regard to our expectation, we continue to believe a flat to up environment for the foreseeable future is probable, putting our FY20 view at +0-3%. This would imply revenue growth for the Primes at MSD through 2022 and annual total returns of 8-10%.

2) Stocks have de-rated considerably and underperformed other low beta peers. Earlier in the year, Defense stocks were trading at ~20x 1-year forward P/Es and were at a ~20% premium to the broader market. Now, they trade at 14-15x and are at a ~10% discount, albeit in-line with the historical average. In addition, shares are down ~10% YTD and have underperformed the S&P 500 by ~8 points. This is surprising when looking at peers like Utilities and Consumer Staples that are trading at 17x-20x and have in some cases outperformed the market as much as ~10 points.

Looking forward, we believe the total return profile of Defense stocks (assuming budget stability) and betas are more aligned (or are superior) versus such peers. This underpins our valuation stance on the Defense stocks, which are for P/Es at a 1-2 turn premium to the market given at least average growth vs. the market alongside below average risk.

3) Defense should do well in a period of economic uncertainty. Clearly, there is growing concern around easing economic growth and uncertainty ahead for most companies within our coverage as well as Industrials and markets overall. In fact, our firm is pointing to a greater than 50% chance we experience a modest earnings recession in 2019.

Defense stocks on the other hand will have P&Ls that are less sensitive to the broader backdrop as government spending runs on a different cycle, while having limiting trade exposure, transacting in USD, and have investment grade balance sheets. And assuming that the above is accurate in regard to rising Defense spending in FY20, there is the potential for visibility of 2-4 years of growth as outlays of DoD dollars occur on a lagged basis. Moreover, in the event our forecast proves correct on spending, we believe it indicates topline expansion in the MSD range and EPS / FCF per share growth in the HSD range, pointing to annual total returns of 8-10%. As discussed above, this screens well in the current environment when coupled with low beta and discounted valuation.

In regard to the stocks, our preference remains RTN / LMT (both OW), followed by NOC (EW), and then GD (UW).

To start, we acknowledge that correlations amongst the Defense stocks tend to run high (~0.85 over the last 5 years). Having said that, our preferences within the group are for companies with elevated modernization exposure, longer cycle visibility, and more international sales (i.e. more diversification).

Accordingly, our preferences are for RTN / LMT, followed by NOC, then GD. We provide our investment thesis for each below:

-- RTN (OW) / $221 PT – RTN is our top pick within Defense.
It has an under-levered balance sheet (~0.3x Net Debt to EBITDA on 2019), opportunities around its portfolio (such as Missile Defense, commercial cyber monetization, and hypersonics), a leading international portfolio (~30% of revenues), and one of the better margin profiles. Our PT is premised on a premium ~18.5x 2019 P/E with $11.95 of EPS.

-- LMT (OW) / $366 PT
The company has meaningfully enhanced the outlook as it successfully adds to revenue opportunities away from the F-35 (25-30% of revenues) via wins in hypersonics, potential at RMS (e.g. Sikorsky and ships), and generally leading topline post budget increases. These pair well with a growing international portfolio and leading dividend yield (~3%). Having said that, we will continue to monitor implications of pension on longer-term EPS / FCF growth post 2020. Our PT is premised on a premium 18.0x 2019 P/E with $20.32 of EPS.

-- NOC (EW) / $318 PT
The company continues to go through a leadership transition and contends with peers like RTN / LMT having accelerated topline growth into 2019 (5-8%). That being said, we believe NOC’s growth potential over a multi-year period is considerable, both on revenues (e.g. F-35, B-21, GBSD, and Space) and margins (e.g. synergies and maturing programs). Moreover, there remains opportunities around its portfolio via Technology Services as the new CEO optimizes exposures. Our PT is premised on an in-line 17.5x 2019 P/E with $18.18 of EPS (before pension accounting shifts).

-- GD (UW) / $189 PT
Our cautious stance on GD is unchanged. We prefer Primes with less exposure to commercial and services-oriented business (~45% of revenues), even if the core Defense business is well-positioned (e.g. ~3 year Marine backlog), and believe that bizjet risks are heightened as we get later in the cycle while new products are being introduced and margins are considerably higher versus peers. And at roughly similar EPS / FCF valuations, the relative risk-reward does not skew favorably, in our opinion. Our PT is premised on a discount ~16.0x 2019 P/E with $11.81 of EPS.


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