NOC closed OA acquisition on 6/6, in line with its 1H18 timing and roughly nine months after announcing the deal. OA is NOC’s fourth business sector called Innovation Systems and is led by Blake Larson, OA’s COO before the acquisition. There were some who assumed that the NOC-OA combination could inhibit competition, particularly on applications that require solid fuel rocket motors like the upcoming GBSD competition between primes NOC and BA. But the FTC approved the deal contingent on NOC creating firewalls between the acquired solid fuel rocket motors business and the rest of the company, and NOC agreeing to provide these motors to competitors on a nondiscriminatory basis. The DoD’s acquisition and sustainment office will monitor NOC for compliance.
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It is widely understood that management teams at the defense primes are conservative with their EPS guidance. We looked at how each company’s initial guidance and initial consensus estimate stacked up to actual earnings over the last 10 years from 2008 to 2017. On average, actual results beat initial guide and expectations by 7% and 5% during this time frame. Of course, there are some nuances as we discuss below.
BA agreed to form an auxiliary power unit (APU) JV with Safran. The partnership will target commercial transport platforms and both companies will have a 50% stake. The deal is expected to close in 2H18 and won’t impact BA’s 2018 guide or its commitment to return ~100% FCF to shareholders. Today’s announcement underscores BA’s efforts to capture more of the lucrative aftermarket content that powers most suppliers. Earlier this year, BA announced its acquisition of KLXI’s aerospace fasteners and consumables business and seating JV with Adient. Before that in mid-2017, BA indicated plans to enter into the avionics business.
The Senate Armed Services Committee completed its markup of the $716B FY19 National Defense Authorization Act (NDAA) last week and approved the measure 25-2. The Senate version included $618B for the discretionary base budget and $69B for OCO. Also included in the bill was language that urged President Trump to sanction Turkey if it finalizes the purchase of the Russia-built S-400 air and missile defense system. Separately, three senators – Thom Tillis (R-NC), Jeanne Shaheen (D-NH), and James Lankford (R-OK) – introduced a bill that would prevent Turkey from acquiring LMT’s F-35s and establishing a maintenance depot for F-35s. This follows similar language in the House Armed Services Committee’s NDAA that prohibits any FMS activity to Turkey (including F-35 sales) until Secretary of Defense Jim Mattis submits a report to congressional defense committees on the U.S.-Turkish relationship. Turkey plans to acquire 116 F-35As, and the Erdogan government indicated it would retaliate if U.S. prohibits Turkey from participating in the F-35 program. We’re unsure what the outcome would be on this since we see concerns on both sides: would Turkey potentially share sensitive F-35 technology to our adversaries; and would F-35 unit prices potentially go up without Turkey’s planned order?
Many defense contractors have large pension plans. Accounting associated with these plans are confusing in part since these companies need to calculate pension costs under two methods: 1) Financial Accounting Standards (FAS) for U.S. GAAP and 2) Cost Accounting Standards (CAS) to recover allowable pension costs from the U.S. government. Given all the moving pieces from the recent accounting rule change separating service and non-service costs (ASU 2017-07) to primes prefunding plans to take advantage of the higher tax deductibility, we get why investors might be confused. In a nutshell, we expect the FAS/CAS benefit to the P&L will last at least through early 2020s, and we believe primes will continue to recover prior pension prepayments well into the next decade. Put differently: cash income from CAS should continue at elevated levels for years to come.
We are downgrading shares of TDG to PP from OP as the stock has almost reached our $341 target price, which we derived using a 21x target P/E multiple on our prior CY19 EPS estimate. We try to stay disciplined on valuation in our A&D coverage and that tactic has proven especially useful with TDG. So, with the stock nearing our fair value we, again, have three options: 1) raise estimates, 2) change our valuation approach, or 3) downgrade. We stressed our model to the upside, but on the first option we couldn’t get numbers to work. The second option means not being disciplined on valuation. So that leaves us with the third. TDG just reported strong earnings and the recent run in the shares feels warranted, but we move to the sidelines here while things feel good with the story.
Our 11th Annual Global Transport Conference takes place on 05/22/18 - 05/23/18 in NYC, and we have ~60 Transport, Airline, Cruise, and Auto Retail companies scheduled to present and/or host 1x1 meetings.
We are upgrading shares of RTN to OP from PP and establishing a $240 target price derived from our DCF analysis. Our upgrade is based on 1) valuation, 2) continued favorable outlook on the demand environment for defense and RTN products, and 3) RTN’s diverse and diffuse portfolio. Nothing really changed fundamentally, we simply think the stock pulled back too much after an otherwise ho hum earnings season, and we’re jumping on the opportunity to upgrade the stock of a good company in a good space. Our long-term operating assumptions are unchanged: we’re still projecting 2% long-term growth, 15% long-term EBIT margins, and a 7.2% discount rate. Our DCF derived target price of $240, equates to 20.4x our 2019 FCF estimate (or 4.9% FCF yield) and 20.9x our 2019 EPS (link to our RTN note).
SPR reported 1Q18 adjusted EPS of $1.10, widely below our $1.40E and consensus of $1.35. Downside came from higher opex (~$20-30M) reflecting more overtime, expedited freight costs, and surge resources needed to offset supply chain delays on the 737. SPR is working with ~15 suppliers out of ~600 to get them back on track, and it expects to deliver 737 shipsets on time by June. However, shares of SPR rallied 8% intraday as investors looked past this execution issue and instead focused on SPR’s strong capital deployment strategy and the Asco acquisition.
TDG reported F2Q18 adjusted EPS of $3.79, above our $3.68E and consensus of $3.66. Upside came from better-than-expected sales (+$0.09/sh) and other non-operating items (+$0.08/sh) offset by heavier operating expenses (-$0.06/sh). More importantly, comm A/M and defense sales trends appear to be strengthening as evidenced by TDG taking up its full-year guide. Overall, solid quarter but TDG shares closed -2% pressured by a difficult market.
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