Ron Epstein has been covering the aerospace business for Merrill Lynch since 2001. Before that, he was an engineer at Boeing (BA) —one of the many defense and aerospace firms whose shares have soared above the market for several years.
With defense stocks stalling ahead of the midterm elections, we asked the 51-year-old analyst to re-evaluate the sector. He sees plenty of headroom for Boeing, Lockheed Martin (LMT), and General Dynamics (GD), among others.
Q: How will Tuesday’s vote affect defense spending?
A: The change to Democratic control of the House is the best scenario for defense spending. It points to upside in the defense budget. Gridlock keeps budgets intact, and defense is a bipartisan issue.
Q: Is there fuel left in aerospace stocks?
A: Both commercial and defense seem to be in very strong shape right now. Global air travel continues to rise at a better-than-Goldilocks pace—strong, but not too strong. It has driven a lot of demand for airplanes—for both Boeing and Airbus (EADSY). So that’s one important thing.
A second thing is that we are in a really robust defense-spending cycle. Everybody in the defense business has had a healthy backlog buildup—to a book-to-bill (orders coming in versus orders going out) that’s between 1.2 and 1.5. We’re in the midst of an upturn that started in 2016, President Barack Obama’s last year. Then you had follow-through with the current administration. We are looking for a peak in defense budgets no earlier than 2021...most likely 2022 or 2023. And outlays lag behind appropriations. So we are thinking that outlays will probably peak in 2023, 2024...maybe 2025.
Q: Boeing makes planes for commercial and defense uses.
A: As I said, the long-term average growth in air traffic is 4.8% to 5% globally. But lately, it has been growing at 6.5%. Boeing has very close to seven years’ worth of production backlog for its 737 narrow-body aircraft. Even if you are a major airline, you can’t get one until 2022.
Q: How are they doing at cranking up 737 production?
A: They hit a couple of speed bumps. There was an issue getting fuselages from a company called Spirit AeroSystems Holdings (SPR). Then they had issues getting engines on time. You are seeing a transition to a generation of airplanes that is really predicated on new engines, and these new engines have a supply chain that is still maturing.
They seem to be recovering. This last quarter, Boeing delivered more than what a lot of people were thinking, given what was going on with fuselages. In Spirit’s last quarter, they did better delivering fuselages. And on the engine side, I think it is just a matter of time.
Q: How about that newfangled 787 Dreamliner?
A: The 787 turned out to be a fantastic success. Airlines around the world love it. Having a 250-seat airplane that can fly 8,000 nautical miles, at a very affordable cost per seat, is something that a lot of the global airlines like. It’s a very expensive airplane to build, but Boeing has taken a lot of costs out and gotten more efficient at making it.
Q: OK. How high can Boeing shares go?
A: At a recent $365, we rate it a Buy. Our 12-month price objective is $450. That’s a price/earnings ratio of around 19 times next-12-months’ earnings and a free cash flow yield of 7%—which is pretty darn good.
Q: You’re optimistic about the business-jet market.
A: There are three segments. There is the small aircraft, the midsize, and then the large. The light and midsize segments really got hit hard after the financial crisis. But the large-aircraft segment is more global and has a different buyer profile. It has had ups and downs since 2008, but has broadly performed better. When oil prices declined from $100 a barrel down to the $30s, that had a big impact on large aircraft. That segment seems to be generating momentum now. Inventories of used business jets available for sale are at 20-year lows. If you look at business-jet takeoff and landing activity, you’re approaching a level that we saw back in 2006, 2007. So the market is looking pretty healthy.
Q: This bodes well for which companies?
A: You’ve got General Dynamics, with the most well-known brand, Gulfstream. Bombardier (BDRBF) has the Global and Challenger brands. There are also Dassault Systemes (DASTY) and Textron (TXT).
The name we like the most is General Dynamics. Its Gulfstream is positioned beautifully, as the marquee brand. And then they have a wonderful defense business.
You have this nice balanced portfolio between a commercial business and a defense business. Sometimes, investors like that; sometimes, they don’t. Boeing is a mixed portfolio, too. But Boeing tends to be more strongly identified with commercial, and General Dynamics tends to be equally identified with both industries. With General Dynamics, you can catch some of the recovery in business jets and own a very decent defense business.
Q: Tell us about General Dynamics’ defense business.
A: They have a number of big shipyards: Electric Boat, Bath Iron Works, and Nassco. Right now, we are in a bull market for submarines. The Virginia-type submarine is replacing the Los Angeles class of attack subs. The Columbia class replaces the Ohio class of ballistic-missile subs. That all bodes very well for their ship business.
On land, they sell armored vehicles, with big foreign customers like Saudi Arabia.
They have a land-systems business that is both domestic and international. It is roughly a 50/50 breakout.
Q: Do you expect any change in sales to Saudi Arabia, given the kingdom’s current controversies?
A: Defense companies have said that they don’t expect much change, and I tend to agree with them on that.
Q: General Dynamics stock is cheaper than other defense shares, right?
A: On the next-12-months’ earnings, you are talking about a company that is trading at 14 times—so a very inexpensive P/E. On a free-cash flow yield, it is about 7.5% on the next 12 months.
Q: And your price target?
A: My price target is $230. Today, it is trading around $180.
Q: Who do you like on defense?
A: For a pure-play defense, Lockheed Martin is the bellwether. They’re the largest defense company in the world and the prime contractor on the F-35—the largest defense program in the world.
Q: What’s the trajectory of the F-35 program?
A: This year, they’ll deliver about 90 airplanes. Next year, 130. The year after, you are up to about 150. There is an open debate whether 160 will be the peak or not. It is a program that was designed to be international. So, if you get more traction internationally, you can see numbers higher than 160. I believe the company is capitalized today to go 180.
Interestingly, Belgium just picked the F-35 over the Eurofighter. If you think about the European Union’s capital, Brussels, buying a U.S. airplane, it’s a real vote of confidence for the F-35. And once you start talking about numbers in the mid-100s, it becomes a very significant profit driver across the company.
Q: Lockheed is involved in lots of exotic programs. You have hypersonic missiles, space stuff.
A: Yes, it is not just an F-35 play. They’ve made the littoral combat ship, and that has given birth to a whole industry for them serving the brown-water Navy’s coastal missions. And they recently purchased the helicopter maker Sikorsky Aircraft—so between their fixed-wing business and their rotor-wing business, they are the largest producer of military aircraft in the world.
Q: How big a deal are hypersonic missiles?
A: If you have near-peer potential threats that have hypersonics, you have to have hypersonics, too. A lot of research is being done. This last quarter, Lockheed said that their hypersonics business is about $1.5 billion, and I would expect it to grow pretty aggressively. There is a lot of classified work going on there.
Q: Isn’t Lockheed’s pension newly relevant to its earnings?
A: Pensions are relevant for all of these companies. Lockheed made a big pension contribution this year, so they won’t have to do that for a couple of years. That means you get a nice little jump in their cash flow and some good tax benefits.
Q: So what do you see for the stock?
A: Our price target is $390, and the stock trades today at about $306. On the next-12-months’ P/E, it is maybe 15 times. And their free-cash-flow yield is about 6½ times—with a dividend yield of 2%.
Q: You’ve said the Navy’s buying a lot of ships.
A: Another beneficiary of what is going on with U.S. Navy spending is Huntington-Ingalls Industries (HII). They make aircraft carriers. They make the Virginia-class submarines with General Dynamics. They also make the guided-missile destroyers known as DDG-51. It is a more volatile stock, and a mid-cap, but attractively valued.
Q: And you rate it a Buy?
A: That’s why I brought it up. Our price projection is $335. Today, it is trading around $229, so it is like 13 times the next 12 months’ earnings, with a free cash yield that’s 6.5%. It’s attractively valued.
Q: What else have you got for us?
A: There is a shortage of pilots, and you’ll need a lot of pilot training. The mainline airlines are taking pilots from regional airlines, and then regional airlines don’t have enough pilots. So an interesting play is a Canadian company called CAE (CAE). It is one of the leaders in making flight simulators and in pilot training. Then, in defense markets, there is an increasing focus on using simulation for training as a way to save money.
Q: What do you think happens to the stock?
A: We think it is worth about $30, and it is trading today around $23. On next-12-months’ numbers, it is an 18 times P/E, and they have a free-cash-flow yield that’s 6%.
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