The View From Wall Street: What Investors Think of the Defense Sector

Transcription

1 The View From Wall Street: What Investors Think of the Defense Sector Presented by: Pierre A. Chao Managing Director (212) National Defense Industrial Association 2003 Munitions Executive Summit Falls Church, VA February 12, 2003

2 Page 2 Disclosures Investors should assume that CSFB is seeking or will seek investment banking or other services from the covered companies. For important disclosure information regarding the Firm's rating system and potential conflicts of interest, please equity.research@csfb.com or call (877) CSFBC and/or its affiliates have managed or co-managed a public offering of securities for the subject company (ANT, ATK, BA, IDE, LLL, MOGA, RTN, UDI, VNX) within the past twelve months. CSFBC and/or its affiliates have received investment banking related compensation from the subject company (ANT, ATK, BEAV, BA, GR, IDE, LLL, LMT, MOGA, NOC, RTN, TRW, TTN, UDI, VNX) within the past twelve months. CSFBC and/or its affiliates expect to receive or intend to seek investment banking related compensation from the subject company (ANT, ATK, BEAV, BA, COL, GD, GR, GRMN, IDE, LLL, LDSH, LMT, MOGA, NOC, PCP, RTN, TRW, TTN, UDI, VNX) within the next three months. As of the date of this report, CSFBC makes a market in the securities of the subject company (BEAV, GRMN, LDSH). In addition, CSFB s foreign affiliates may have: (1) managed or co-managed a public offering of the company s [ANT, ATK, BEAV, BA, COL, GD, GR, GRMN, IDE, LLL, LDSH, LMT, MOGA, NOC, PCP, RTN, TRW, TTN, UDI, VNX] securities in the past 12 months, (2) received investment banking compensation from the company [ANT, ATK, BEAV, BA, COL, GD, GR, GRMN, IDE, LLL, LDSH, LMT, MOGA, NOC, PCP, RTN, TRW, TTN, UDI, VNX] in the past 12 months, or (3) expect to receive or intend to seek compensation for investment banking services from the company [ANT, ATK, BEAV, BA, COL, GD, GR, GRMN, IDE, LLL, LDSH, LMT, MOGA, NOC, PCP, RTN, TRW, TTN, UDI, VNX] within the next 3 months. With regard to its foreign affiliates, CSFB is not making certain disclosures required by NASD Rule 2711 and NYSE Rule 472 until the date that it actually complies with these requirements, which will be no later than November 6, 2002.

3 Page 3 Defense Investment Dynamics

4 Page 4 Mental Models A Way of Approaching the Stock Market Investors approach the stock market with a set of mental models - composed of rules of thumb, images and mental tools Mental models are necessary to sort through and process a huge amount of information within a short time frame Mental models are generated Internally by investors - experience, trial and error, conventional wisdom Externally by the aerospace/defense industry - raw data, management, investor relations, communications team via the press

5 Page 5 Mental Models Any of These Sound Familiar? The commercial aerospace industry is a deeply cyclical industry - prone to booms and busts Defense companies are sexy utilities - they are stable, never miss numbers and predictable Boeing is a commercial aerospace company (corollaries: never invest in Boeing during a downturn in commercial aircraft orders or when R&D as a percentage of sales is going up) The defense budget is in decline MENTAL MODELS ARE OFTEN SLOW TO CHANGE!

6 Page 6 Defense Investment Environment Relative Stock Performance Defense Defense Electronics S&P /31/90 10/25/91 5/19/92 12/09/92 7/02/93 1/24/94 8/17/94 3/10/95 10/02/95 4/24/96 11/13/96 6/09/97 12/30/97 7/24/98 2/17/99 9/09/99 3/31/00 10/23/00 5/17/01 12/13/01 7/10/02 1/31/03 Defense = Alliant Techsystems, General Dynmics, Grumman, Litton, Lockheed Martin, Martin Marietta, Northrop, Northrop Grumman, Newport News Defense Electronics = E-Systems, L-3 Communications, Logicon, Loral, Raytheon, Tracor

7 Page 7 Defense Investment Environment Relative Stock Performance Defense Defense Electronics S&P What s Been Going On? 0 12/31/90 10/25/91 5/19/92 12/09/92 7/02/93 1/24/94 8/17/94 3/10/95 10/02/95 4/24/96 11/13/96 6/09/97 12/30/97 7/24/98 2/17/99 9/09/99 3/31/00 10/23/00 5/17/01 12/13/01 7/10/02 1/31/03 Defense = Alliant Techsystems, General Dynmics, Grumman, Litton, Lockheed Martin, Martin Marietta, Northrop, Northrop Grumman, Newport News Defense Electronics = E-Systems, L-3 Communications, Logicon, Loral, Raytheon, Tracor

8 Defense Investment Environment Page Defense Defense Electronics S&P x 8.5x 10.2x 11.1x 8.9x 12/31/99 2/18/00 4/07/00 5/26/00 7/14/00 9/01/00 10/20/00 12/08/00 1/26/01 3/16/01 5/04/01 6/22/01 8/10/01 9/28/01 11/16/01 1/04/02 3/01/02 4/19/02 6/07/02 7/26/02 9/13/02 11/01/02 Aggressive Growth/Mo 3.5% 5.4% 6.2% 7.5% 11.6% 11.6% Growth GARP Value Index 21.3% 20.0% 21.5% 20.3% 20.2% 20.8% Defense = Alliant Techsystems, General Dynmics, Grumman, Litton, Lockheed Martin, Martin Marietta, Northrop, Northrop Grumman, Newport News Defense Electronics = E-Systems, L-3 Communications, Logicon, Loral, Raytheon, Tracor

9 ATK (Alliant Techsystems) Page /01/ /19/ /06/2000 1/25/2001 3/14/2001 5/01/2001 6/18/2001 8/03/2001 9/26/ /12/ /31/2001 2/19/2002 4/08/2002 5/23/2002 7/11/2002 8/27/ /14/ /29/2002 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q02 1.6% 2.5% 3.4% 3.6% 2.9% 19.9% 24.3% 20.8% 23.6% 28.4% Mo/Aggressive 9.1% 16.0% 18.2% 20.2% 19.0% 20.7% 22.1% 22.6% 25.2% 26.2% Growth 39.0% 34.6% 35.9% 37.0% 41.1% 29.7% 21.2% 24.1% 24.2% 22.4% GARP 36.4% 33.0% 27.7% 23.1% 18.2% 12.5% 14.6% 14.6% 10.6% 10.4% Value 13.8% 13.9% 14.8% 16.1% 18.7% 17.2% 17.7% 17.9% 16.3% 12.6% Index 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

10 Lockheed Martin Page /01/ /16/ /28/2000 1/11/2001 2/26/2001 4/09/2001 5/22/2001 7/05/2001 8/16/ /04/ /15/ /31/2001 2/13/2002 3/28/2002 5/10/2002 6/24/2002 8/06/2002 9/18/ /30/2002 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 0.5% 2.5% 2.6% 2.4% 2.5% 2.9% 4.5% 4.7% 4.0% 5.4% Mo/Aggressive 9.8% 8.9% 7.1% 7.8% 10.3% 11.0% 12.6% 14.8% 16.5% 17.9% Growth 10.3% 10.4% 10.3% 10.2% 10.9% 12.1% 13.2% 15.6% 16.8% 16.6% GARP 45.7% 46.6% 51.1% 49.7% 46.3% 44.4% 39.9% 33.8% 33.1% 31.0% Value 33.7% 31.6% 28.9% 29.8% 30.0% 29.6% 29.8% 31.1% 29.6% 29.2% Index 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

11 L-3 Communications Page /01/ /16/ /28/2000 1/11/2001 2/26/2001 4/09/2001 5/22/2001 7/05/2001 8/16/ /04/ /15/ /31/2001 2/13/2002 3/28/2002 5/10/2002 6/24/2002 8/06/2002 9/18/ /30/2002 1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 4.8% 9.9% 13.8% 14.6% 17.0% 19.5% 23.4% 18.4% 15.3% 17.2% Mo/Aggressive 36.5% 38.2% 33.7% 34.6% 37.1% 34.7% 28.4% 28.3% 32.5% 27.1% Growth 26.7% 23.8% 23.0% 24.6% 22.3% 23.6% 27.2% 27.7% 23.0% 24.0% GARP 23.0% 18.7% 18.9% 15.4% 10.5% 10.8% 10.2% 14.2% 16.7% 12.1% Value 8.9% 9.4% 10.6% 10.8% 13.1% 11.4% 10.8% 11.3% 12.6% 19.7% Index 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

12 Page 12 Defense Investment Environment Mental Models Used By Aggressive Growth/Mo Acceleration is key 6.5% growth FY02 over FY01, 18.8% FY03 over FY02 What about FY04 over FY03? Focus on P/E and GAAP EPS Renters, not owners

13 Page 13 Defense Investment Environment Investors Still Prizes the Industry for its Cash Flows 75% of Investor Polled Said They Used: Discounted Cash Flow of Free Cash Flow Analysis or Price to EBITDA (proxy for cash flow) Analysis or Cash Earnings (proxy for cash flow) Analysis or ROIC Used to be 100% P/ E Other EV /EBITDA

14 Page 14 Defense Investment Environment Mental Models Used By Aggressive Growth/Mo Focus on P/E and GAAP EPS PENSIONS PENSIONS PENSIONS LMT 2003 GAAP EPS = $1.72 vs. economic = $3.42 RTN 2003 GAAP EPS = $1.65 vs. economic = $2.17

15 Page 15 Defense Investment Environment What do other/the rest of the investors think?

16 Page 16 Defense Investment Environment Do you perceive the aerospace/defense industry to be a growth industry? Yes Yes Source: MSDW survey No 2002 Source: CSFB survey No No Yes Source: CSFB survey Long term no In an upcycle now, but no reason to grow equal to GDP over time

17 Page 17 Defense Investment Environment Are you invested in the defense sector now? Valuations too high No Yes Source: CSFB survey

18 Page 18 Defense Investment Environment What are the alternative investments when you consider the defense sector? Transportation Entire Market Capital goods/industrial Commercial Aero Technology Source: CSFB survey

19 Page 19 Defense Investment Environment Why are you invested in the sector? 2000 Earnings Stability Cash Flow Earnings Growth 2002 "Insurance" Consolidation Defense Cycle To make money!!!! Stability/visibility Attract valuation Source: CSFB survey

20 Page 20 Defense Investment Environment Why would you sell your defense investment? Change in strategy Loss of mgmt credibility Other investment Program cancelled Valuation/Price Budget outlook/political Program/Earnings miscues Source: CSFB survey

21 Page 21 Defense Investment Environment Investors Prize the Industry for its Stability What is more important to you: top-line growth or consistency of earnings? Growth 1999 Source: MSDW survey Consist ency Growth 2002 Predictability of source and level of earnings, as opposed to smoothness Consiste ncy

22 Page 22 Defense Investment Environment What is more important, growth or return on capital? Growth Return on Cap Source: CSFB survey

23 Page 23 Defense Investment Environment Investor Confidence Rebuilding Do you think aerospace/defense companies are well managed? Surprises undermined the confidence in consistency of earnings Too insular Small companies better managed than the big ones Yes 1999 Yes 2000 Source: MSDW survey No Yes 2002 Source: CSFB survey No Getting better Mixed

24 Defense Investment Environment Page 24 And Government Policy is an Issue Do you believe the defense industry earns appropriate margins for the risk taken? Yes 2000 Yes given the capital required Not many industries where R&D is funded by customer No given long development cycles Margins too low given the higher risks of the annual budget process and the limited number of programs completed Industry too politicized, which may never be solved improved ROIC would help No Closed market, rarely lose money generate cash at minimal risk Yes 2002 Source: CSFB survey No

25 Defense Investment Environment And Government Policy is an Issue (2) Do you believe the defense industry is healthy? No Page 25 NO Industry still needs to deleverage The length of the procurement process too long, hurts the industry Should always attract capital Yes YES budgets, cash flow, earnings and sentiment improving Balance sheets repaired Now that consolidation is over Procurement reforms and management changes improving returns Managements are tougher and more disciplined Source: CSFB survey

26 Page 26 Defense Investment Environment Key Questions: Future growth rates? Impact of Iraqi War? What is the five year case?

27 Page 27 Leveraging the Financial Markets Financial Jujitsu

28 Page 28 Financial Jujitsu How does the Munitions Buying Community use an understanding of the financial motivations of its supplier base to further DoD goals: Technology innovation Assurance of supply Best value On time, on budget

29 Page 29 Financial Jujitsu Tie rewards that mean something to the industry to performance goals Munitions technology/program milestones Buyers - on time delivery - cost performance - innovation Industry - timing of cash payments (Invested Capital issue) - advance payments for next phase as reward (Invested Capital) - extra normal margins (Return issue) - share of savings (Return issue) - share of investment (Invested capital)

30 Page 30 Financial Jujitsu Use rewards/penalties that make financial sense, are fair and attractive to future investment environment Tie return to cost of capital Defense industry competing for investment, resources and talent versus the rest of the economy - Low Risk work Cost of Capital +/-XX% (small single digit) - Medium Risk work cost of capital +/- XX% (say 4-6%) - High risk work cost of capital +/- XX% (upper single/double digit) A more nuanced system that takes into account past performance A B C Low Risk CoC + 3% CoC + 2% CoC +0% Medium CoC + 5% CoC + 4% CoC +2% High CoC + 8% CoC + 7% CoC +5%

31 Page 31 Financial Jujitsu Fix the throw aways that don t impact policy goals but are important to industry Paid cost rules Facilities as a determinant of margin rates Progress payments Etc. (see Defense Science Board study)

32 Page 32 Financial Jujitsu Out of the box acquisition mechanisms for out of the box ideas - Prize money (to kick start technology) - Venture investment (to kick start technology) - Leasing - Real options (to price surge capacity)

33 Page 33 Financial Jujitsu You need a spectrum of management techniques for the industrial base Look to the product cycle Last of Breed Legacy Future (non-guided missiles) (1 st Gen PGMs) (PGMs) - preserve suppliers - balance competition - competition - accept monopolies? - shrink supplier base - look wide - leverage support - look offshore - innovation - manage capital - returns - investment

34 Creating Value is NOT a Page 34 Zero-Sum Game Government Companies Employees Shareholders A healthy industry is able to attract investment/shareholders, lowering cost of capital, enabling it to invest more in R&D and attract talent, and be a better contributor to national security