Streetwise for Sunday June 14, 2009

Streetwise

Lauren Rudd

Sunday, June 14, 2009

Defense Is Certainly Not Dead

Defense spending, although currently the largest single item in the federal budget, it is not immune from budgetary reductions. The request for fiscal year 2010, beginning October 1, seeks to increase base defense spending by a mere 4 percent, down from the prior year’s 7.5 percent. At the same time, major ongoing projects, such as Lockheed Martin's F-22 fighter jet, are being capped.

Obviously, the continual push for new and more deadly armaments is not going by the wayside. Worldwide political instability, combined with a modicum of unadulterated and senseless idiocy, is unbridled evidence that the world is not ready to beat swords into plowshares, thereby requiring that we continue to maintain an outsized defense budget.

However, with contracts being downsized and some previously lucrative programs being cut in totality, the feeding at the federal trough by defense contractors is becoming less lucrative as the Administration works to contain massive budget deficits, a viewpoint echoed in a Goldman Sachs research report of June 5.

Therefore, defense contractors are being forced to turn to acquisitions for continued earnings growth. Specifically, they are looking to acquire smaller companies that have developed a unique niche, one that is less likely to be axed by either Congress or the Defense Department.

For example, bets are being placed on niche products capable of countering cyber threats. There is also an ongoing demand for technology that adds to the efficiency of military intelligence and our ability to fight insurgency in hostile locations.

Answering the call to arms is a behemoth within the defense contracting world that is capable of both devouring its smaller brethren and meeting the needs and wishes of the Defense Department. The company is General Dynamics (GD) and it recently announced that it was acquiring Axsys Technologies, a company that provides high-end optics for manned and unmanned military vehicles and satellites.

Although not discussed here for several years, General Dynamics’ ongoing strength is evident in their recent first quarter results. Specifically, earnings from continuing operations were posted at $593 million or $1.54 per share, as compared to $573 million, or $1.42 per share for the same period a year ago. The company’s defense business produced double-digit organic growth, demonstrating the depth of demand from the company’s government customers.

Revenues were $8.3 billion, an 18 percent increase over the $7 billion posted for first-quarter 2008. Funded backlog at the end of first-quarter 2009 increased 23 percent from one year ago, to $49.2 billion. Total backlog at the end of the quarter was $71.1 billion, 43 percent higher than the $49.8 billion reported at the end of 2008.

In addition to the backlog, the estimated potential contract value, which represents management’s estimate of value under unfunded indefinite delivery, indefinite quantity (IDIQ) contracts and unexercised options, was $17.9 billion at the end of the first-quarter.

Net cash provided by operating activities from continuing operations in the quarter totaled $154 million. Free cash flow from operations, defined as net cash provided by operating activities from continuing operations less capital expenditures, was $73 million for the period.

The intrinsic value of the shares, using a discounted earnings approach with an earnings growth rate of 9.8 percent and a 10 percent discount rate, is $151 per share. The more conservative free cash flow to the firm model produces an intrinsic value of $120 per share.