Description

We believe the following two statements as our base case:

1. The Chinese ponzi economy is finally starting its long awaited collapse. The CCP will look to geopolitical distractions as a means to maintain power and control. Thus, it is highly likely China will invade Taiwan in the next two years

2. Multipolar world where Russia/China square off against western countries/NATO is going lead to a reversal of the past 40 years of peace, globalization and disinflationary trends. 

We have been searching for ways to play this on the LONG side and besides the obvious commodity/precious metals trade, we think defence equities offer very attractive upside and limited downside.  

So this write-up should be viewed as more of a framework for understanding the economics of the Defence sector, and theorizing the risk-reward for those who wish to play the theme mentioned above on the long side. 

Industry Overview: 

The U.S. / NATO alliance defence sector is a ~1 trillion dollar a year industry, with roughly a third of that yearly amount (~$300-400bn) spent on equipment, products, services, and development which public companies largely deliver. Residual funds are for in house capabilities – standing armies, administration functions etc. Outside NATO and its members, defence contractors also sell to allies around the world (Australia, Japan, South Korea, Middle East) a mix of usually older equipment/ declassified systems – often their highest margin sales.

The industry is highly regulated, consisting of roughly 10 “prime contractors”, 20 “secondary contractors” and then thousands of other suppliers across a very complicated supply chain. 

The large-scale prime contractors are the group of companies that have the size, scale, depth, and ability to lead “platform” programs for the U.S. While there are 10,000’s of programs across the defence department – there are a selection (couple hundred) of what are called platform programs that often last multiple decades, fifty+ years in some cases, and make up the bulk of funds allocated for equipment and servicing. Examples of such programs are the F-35 jet fighter, the Nuclear Triad of defence systems, Aircraft carriers and the ICBC missile defence system. These programs over the life of their careers can be allocated 100’s of billions of dollars. 

The main players that bid for these contracts are General Dynamic, Boeing, Lockheed Martin, Raytheon Technologies, BAE Systems, L3Harris, Textron, Northrup Gumman, Airbus, Huntington Ingalls Industries. Virtually all large US defence programs are led by one of these companies. 

Economic Structure:

All prime defence contractors have similar business models, similar margin structures and compete in a similar, transparent way. Their businesses are built on bidding (and winning) very long cycle and large government contracts. The process itself is rather standardized-- the government puts out a bid request that could take multiple years to determine a winner. Once a winner is chosen, there is a process of engineering and proto-type development, into full scale manufacturing, and eventually – sales to international partners or the commercial sector. Often product re-designs restart the process (think F-16 to the F-35).  The process is heavily regulated across multiple agencies that constantly check things such as cost, progress, deviation from expectations, timing etc.

Almost all of development work done is on a cost-plus basis at mid to low single digit net margins. This is because these projects are technologically complex – with risk of failure, cost overruns etc. So the government effectively assumes the risk. The cost-plus variance – which is in general 50-80% of all contracts for these companies (not just development) come in general in three forms: cost plus fixed fee, cost plus award fee, cost plus incentive fee. These contracts are sometimes referred to by different names but in essence the economic outcome is the same – they are regulated cost-plus fees. The few fixed price contracts are only that in name – they are constantly audited and adjusted to make sure suppliers aren’t making too much margin. In effect – the relationship is such that the government buyers assume full risk – capital / R&D etc – and in return contractors make a set low amount of margin. They are essentially technology pass through vehicles.

All companies, and most budgets, are at the whim of the U.S. defence department (DOD) appropriations on a yearly basis. Although the industry is long cycled and regulated, appropriations happen on a yearly basis and thus there is a constant risk of project delays, cancellations (in which case there is a make-whole mechanism for the players). Bottom up what this creates in the industry is a very flexible supply chain protected from cost overruns and delays in how the contracts are structured, but one with very little operating leverage to increase margins. Defence contractors are some of the most inflation protected businesses you will come across because of how they sign contracts throughout the supply chain – with protection for delays, price increases etc – all flowing from the top (the U.S government) down throughout the supply chain.

Fixed price contracts – some to the U.S. government, but mostly to international partners via the FMS or DCS approved channels (Foreign military sale via the State Department, or a direct commercial sale with Government oversight and signoff), often will be fixed price. Here is an opportunity for leverage even though it is a small percentage of revenue.  However – the U.S. government also highly regulates fixed price contracts through FAR – Federal acquisition regulation and also through CAS (cost accounting standards). Whether from a raw material advantage, or an engineering breakthrough, the U.S. government reviews the margins on every single contract they have continually.  They follow guidelines on the level of profit the government allows the contractor to earn for the work they are doing. The U.S. government will immediately reset those contracts to a sensible level (low double digits at most depending on the product).

One further example of how regulated and structured the industry is – R&D is almost exclusively a pass through from government contracts for the prime contractors. Besides BAE Systems which breaks out £200mn of its total £1.4bn in R&D being “Spec” for other projects, the main players do almost no self-funded R&D.  Lockheed Martin has company funded R&D, and Customer funded R&D. Company funded R&D is in reality once again a pass-through vehicle. In 2021 Lockheed had $1bn of company funded R&D (less than 2% of sales), but this work is almost always done in anticipation of a contract win, or work that’s approved but they can’t bill yet. 

For the second and third tier players – many fund R&D themselves so they can own the tech, use for commercial purposes, and to position themselves to compete for future platforms. The self-funded R&D is really cost plus back to the primes that charge the DOD. One of the interesting things about this secondary group is their ability to own R&D, innovate, and leverage competitive advantages to a degree overtime, more so than primes. Thus some suppliers have been better performers than prime contractors over time, and is also one of the reasons why there is so much M&A in this space.

The other peculiarity of the defence supply chain is working capital. The U.S. defence prime contractors run WC positive businesses, but as they approach the start of big platforms this could turn negative as they prepare for big work. In general, governments feed the supply chain to make sure inventory / products are available and that it works. One consequence of a European pick up in defence spending and of overall foreign sales – is it should be both working capital and margin accretive for the industry. European defence contracts fund up front. On average, the industry generates 20-30% of its sales across the board internationally – which exactly mirrors the size of the relative U.S. versus E.U. + UK defence budgets.

Competition:

The defence industry operates in a unique “competimates” way. Almost all players across the chain compete, but also join forces on projects and platforms. They do this out of necessity because of capacity constraints, sheer size of the platform (too big for any one or group of companies) for risk sharing.

As an example, the F-35 – presently the biggest program in the U.S. DOD. While Lockheed is the lead, the engine is supplied by Pratt and Whitney. Lockheed didn’t have enough manufacturing capacity to create the whole plane, so the fuselage and other parts of the mainframe are manufactured by BAE and Northrup in their facilities in the U.S. Once me move into the plane to the systems, IT integration, avionics, radar, sensors etc.… there are dozens of subcontractors who are all affected enough to list F-35 as key in their filings (Mercury Systems, L3Harris, Leidos to name a few).

The price of a F-35 is roughly $78mn today with 100’s being made every year. 10mn per unit goes to Pratt and Whitney, with ~$68mn being booked by Lockheed of which over 2/3’s is subcontracted out. Large parts of revenue being subcontracted out – a pass through mechanism – is yet another reason margins are low and stable in the space. Platforms being the bulk of revenues in the defence industry, filled with pass through revenues and highly competitive as they often times last decades and primes want to be attached to them – create this fairly stable and low margin predictable backdrop across the space.

Opportunity in this Cycle:

We think there is a generational step change in higher defence spend. This is much bigger than the cold war.

Expansion in budgets is in the first innings.  EU is planning a 100bn modernization fund for their military. This is outside the normal ~1.5% of GDP the group spends on military spending. Sweden and Germany have announced they are heading towards their 2% target of GDP for spending, 3) There is chat of European backed bonds for defence spending. The spending is starting – Germany have announced they are purchasing 35 F-35, they are also poised to acquire and build a missile defence system. As we approach budget sessions in E.U. and U.S. in spring, elections in France, and if the war in Ukraine continues – positive news flow and appropriations should only be beginning. Spending is going higher from multiple different angles.

Extra Spending is going to go almost exclusively to equipment / investment. In the case of Germany – they are going to go from a 1.3% GDP to 2% of GDP in military spend… not over five years but immediately. This is not going to be spent increasing the size of the army – it’s on materials and programs. Germany is increasing its defence spending – the biggest country in Europe – by 50% and almost all of that will be investment.

European defence spending has amounted to ~$300bn a year – Germany hitting its target will add another $32bn (+10% growth) – to the budget. Sweden’s announcement will add another 4bn. All told if NATO countries (+Sweden / Finland / Austria—not included in the NATO budget) hit the 2% target will add $75-100bn in net new spending.

Hitting 2% target GDP for spend would see the entire European budget up 24% and equipment / investment spend up 50-100%. 

Source of opportunity -- Which Programs will lead growth:

Given the long lead time on programs, public debates on programs, amount of parties involved, large lobbying efforts from both the contractors and also U.S. agencies that often times put out reports in support of further funding, one can piece together where spend is likely.

Through due diligence calls with all companies in the space, lobbyists in Washington DC, ex recent employees in the space and general news flow – we have tried to identify the key platforms and programs that should benefit in the coming years. While this list is not exhaustive – these are the programs most often mentioned, highlighted in the FY ’23 budget, with current momentum, being discussed in D.C. and by the companies.

In looking at DOD budgets the past ten years (below), ground based systems have been de-prioritized, maritime remains key part of the budget (prices for Submarines and Aircraft Carriers particularly high, but low margin work), Space based systems and the Nuclear Triad have been prioritized and where spending growth is coming from. 

Northrup is building a moat – Nuclear Deterrent and Space:

Northrup is building a competitive moat in space and nuclear deterrence – arguably the two largest areas of spending going forward outside the F-35 program. They are sole-source on the two of the three programs in the Nuclear Triad – deemed the “backbone” of American defence. In 2020 they also won the sole contract for the upgrade to the ICBM (missile defence) program—Boeing dropped out as they thought they couldn’t compete with them (price and quality). The ICBM is a collection of missile-based delivery systems and deterrence – already being discussed as a key area of investment in Eastern Europe. Just this week, Germany announced it is eyeing purchasing their own system which would be a program that costs 10’s of billions of dollars over multiple years.

Conversations in industry with suppliers – support the view that in terms of mission critical defence and delivery systems – space, shields and deterrence – Northrup recently has moved ahead of the pack. This can be seen through their sole source wins and revenue growth in the segments. The last three years, Northrup has achieved 13% rev CAGR in their Space division while peers have been effectively flat. Supplies have recently been mentioning the importance of Space systems on their earnings calls and in presentations – it’s obvious this has become an area of focus.

While Lockheeds D&A is in Aerostructures (Airplanes and missiles), Raytheon in propulsion (Aircraft, ground to air defences), Northrup has been winning and accelerating wins across Space (their fastest growing segment), deterrence, and a swarm of mission critical and missile defence systems. They seem well placed to capitalize as risks in Europe and the far east start to be prioritized in appropriations.

The FY 2023 budget published this week sees big growth in areas Northrup is exposed to. While the budget is expected to rise 4%, Space spending is expected to go up 40% on FY ’22 just announced and 50% on FY21 levels. Space spend is increasing from $18bn in FY 21 to $27.6bn in FY 23. The DOD is prioritising Space—Northrup is the key, growing player. 

Earnings Sensitivity:

When we try to flex for earnings sensitivity – who can capitalize top down from a higher budget, historical relationship to it, and exposure to the programs we see most likely to drive spending and announcements going forward – BAE Systems and Northrup Gumman stand out. With the US budget compounding at 10% a year ++ the next couple years, and the EU budget approaching spend equalling 2% of GDP by end of FY23 – we see 30-40% upgrades to consensus earnings needing to filter through in this spending scenario. 

The last two months has seen confirmation of budget increases. This is a fact and won’t be reversed for years with almost certainty.  Defense is a long cycle business – every single defence company has yet to quantify expected revenue and earnings increases going forward (the first of these we expect to come with Q3 results where primes such as Lockheed could give ’23 guidance).  

The US executive has requested mid-single digit nominal growth ($773bn request)—an increase to the previous years as the new defence up-cycle begins (historically cycles last 5+ years due to the length of projects that get commissioned – they need years of appropriations or end up being unfinished projects). You can see below the pattern over time in budgets:

The budget is fully expected to increase to mid-single digit real growth once congress reviews and adds their own projects (all 50 states have defence projects operating in them they want to grab funds for) and unfunded priorities are filled. This also doesn’t include further “special – one off” transfers to Ukraine. Overall – we are comfortable with our $850bn ’23 estimate (seemingly optimistic two months ago) for the US budget – in fact we believe we are being conservative. Our due diligence checks across Washington confirm that congress is in full “war” mode, and congressional districts are hunting for projects (and money)—to bring to their states. On both sides of the aisle – this is viewed as a midterm must / winning position.

The German modernization fund is now a reality – 110bn euros being set to be voted in by German Parliament having cleared the debt hurdle by constitutional waver. Of a total European wide base of $200bn alone – this special fund is meaningful. To be deployed over multiple years, this plus the over dozen NATO nations that have agreed to increase spending to 2% of GDP – have us very comfortable with our European defence growth growing from ~$220bn  to $280bn by ’23 --- while still growing into the future. There is a big catch up they need to do. If all NATO members were to go to 50% of GDP.. this would lead to a 50% increase in the European defence budget ~15% growth to the current total EU and US DoD budgets.

Valuation table

Assuming defence budgets increase 40% over the next three years, we get to potential EPS for the group that is significantly above 2023 consensus. We are using historical avg PE to get to our price targets. But to be frank, we think these numbers and multiples will be very conservative post any China-Taiwan conflict. But as a starting point it is instructive to look at where the stocks are trading given the repricing higher post the Russia-Ukraine conflict.  

Risks

Coup in Russia that leads to a less antagonistic government. That said the cat is out of the bag. Countries will not reverse their defence spending decisions. The wake up call has been heard loud and clear especially in Europe.

Catalyst

Defence budget pronouncements

China decides to invade Taiwan

Russia uses tactical nuclear weapons or chemical weapons