DISCLAIMER: This note is intended for US recipients only and in particular is not directed at, nor intended to be relied upon by any UK recipients. Any information or analysis in this note is not an offer to sell or the solicitation of an offer to buy any securities. Nothing in this note is intended to be investment advice and nor should it be relied upon to make investment decisions. Cestrian Capital Research, Inc., its employees, agents or affiliates, including the author of this note, or related persons, may have a position in any stocks, security or financial instrument referenced in this note. Any opinions, analyses, or probabilities expressed in this note are those of the author as of the note’s date of publication and are subject to change without notice. Companies referenced in this note or their employees or affiliates may be customers of Cestrian Capital Research, Inc. Cestrian Capital Research, Inc. values both its independence and transparency and does not believe that this presents a material potential conflict of interest or impacts the content of its research or publications.

Treading Water

We cover many defense stocks, coming at them from the space angle. We’re expert in space sector investing and as luck would have it, space is driving defense growth. Well, not luck exactly. Since the 1950s, jeux sans frontieres in space have served as the marketing department for defense proper. Between the US and the USSR first time around, each country outdid the other to pull off feats wherein as intended, the people were amazed. Satellite in orbit, dog in orbit, human in orbit … USSR ahead. Spacecraft rendezvous, spacewalk … USSR ahead. Then US spending got serious and the home team started winning from behind. It was an acquisition, of course, that delivered the US the victory first time around. The design genius acquired when Wernher von Braun was plucked from Europe and planted in Huntsville, AL, was the foundation for the US’ eventual victory. Design skill coupled with truly huge amounts of spending that the US alone could afford. A second Manhattan Project in short.

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Fast forward to 2020. The US federal space program caught a cold during the financial crisis and as a result of the shuttering of many NASA and other government programs, two things have happened. First, venture capitalists are starting to make money from their space sector investments. The poster child being SpaceX (SPACE) which will, we hope, IPO one day. Where the government has stepped back, private companies and investors have most certainly stepped in. Second, a different incarnation of the original Space Race is now upon us. The opponent this time is China, whose space technology isn’t uniformly excellent and whose safety standards are lower (ergo its stuff is cheaper) but they do in fact have a lunar rover on the wrong side of the Moon right now, the side that cannot ever see Earth. To aid with the radiocomm, they also have a satellite relay station in lunar orbit. Yes, this is happening now, whilst the US is still agonizing over the cost of the SLS rocket, the Artemis program, wondering how on Earth Boeing (BA) was so colossally embarrassed by the SpaceX performance on Commercial Crew thus far, and other internally-focused wrangles.

Whoever occupies the White House after the election has this real-world problem to deal with. China is number 1 on many global measures. The US was number 1 on those measures. China intends to continue to climb. Most folks in the US don’t see the US as playing second fiddle to anyone. And so the newly elected President, whoever he may be, in our view has to power up the US space program and with it the US defense program in order to walk the walk as well as talking the talk.

And that, we think, means a positive future for the leading defense stocks, all of whom have meaningful space divisions, most of whom acquired those divisions or material parts thereof. In the case of Lockheed Martin (LMT) that was the acquisition of Martin Marietta in 1995, for Northrop Grumman, the acquisition of Orbital ATK in 2018, and so forth.

In that context, we were at Buy in our subscription service going into Q3 earnings for LMT. The stock chart has consolidated into a suitably 2020-like, anything can happen pattern. Could go up, could go down. (That’s what our decades of investing experience gets you folks. Could go up, could go down).

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LMT usually beats and raises and we figured this time would be no different. It wasn’t. Beat and raise. Great numbers. Here are the numbers.

Source: Company SEC filings, YCharts.com, Cestrian Analysis

TTM revenue growth of +10% (on revenue of $64bn, no mean feat), stable margins, continued deleverage to a thoroughly-capital-inefficient 0.9x TTM EBITDA before retirement obligations. In other words, what good looks like.

Backlog kind of flat which is a nag; at NOC backlog is up +25% year on year as a result of big wins in the nuclear renewal program, at Aerojet Rocketdyne (AJRD) backlog is up almost 50% on recent nuclear and NASA wins; so flat at LMT is a little disappointing.

Despite the solid quarter and the depressed price going in, the stock headed for the basement and commenced digging.

Here’s what you’ll pay for this 10% growing, almost-unlevered big ol’ stable company as of today’s close.

1.7x TTM revenue and 11.3x TTM EBITDA. Read that again. And then remind yourself why you haven’t bought the stock already.

Well, here are some reasons not to.

  • Sequential quarter to quarter backlog growth is kind of miserly, barely up in Q3 vs Q2; also backlog growth is lower than recognized growth which suggests a slowing in recognized at some point.
  • Management guidance comments were for a miserly – 2.7% revenue growth in 2021 (down from a TTM of 10% in Q3 2020 and would be down from around 9% TTM at Q4 2020 if they hit their 2020 guide). So you have to say – with backlog growth around 9% and TTM growth exiting 2020 at 9% … why would 2021 suddenly grow at 3%? We are guessing that this is conservative but that’s just a guess.
  • Using cash to increase dividends and buybacks, etc, which yes is popular in some quarters but honestly lacks a whole lot of imagination. If management is being cute we suppose a 3% revenue outlook for 2021 helps the buyback pricing. At 0.9x TTM EBITDA leverage we would like to see the company getting bold and choosing to play another Martin Moment. (Like buying Maxar Technologies (MAXR) for instance).
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But the big call with LMT is: what happens to defense spending come November? We’re optimists on this. We think the US has no choice but to step up on this front, unless it is going to choose a path of managed decline over the next fifty years (a foreign policy playbook available at all good bookstores in the UK. Where they still have a lot of bookstores because, you know, people used to like books back when the UK was on top, and who needs all these new-fangled computer thingummies anyway).

Whether you choose to own LMT at this point, we think, comes down to – are you a momentum investor / trader (in which case this piece-of-wet-string stock behavior will have you thoroughly bored already and you will have bailed by now), or do you see this as a pre-election doldrums position still.

Speaking for our staff accounts, with hope in our hearts we remain at Buy on LMT and we remain owners of the stock.

Cestrian Capital Research, Inc – 22 October 2020.

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Disclosure: I am/we are long LMT, NOC, MAXR. Business relationship disclosure: See disclaimer text at the top of this article.

Additional disclosure: Cestrian Capital Research, Inc staff hold personal account long position(s) in LMT, MAXR and NOC.

Via SeekingAlpha.com