On Friday 5/24, the Trump administration declared an emergency over concerns with Iran to bypass the normal 30-day Congressional approval process to sell arms and other military equipment to Saudi Arabia, Jordan, and the UAE. We believe this decision was in response to Sen. Bob Menendez’s (D-NJ) year-long hold preventing the sale of precision-guided munitions to Saudi Arabia and the UAE. Secretary of State Mike Pompeo indicated a total of 22 pending, individual sales worth $8.1B would be cleared through this emergency provision. Not surprisingly, this prompted outcry from Congress since it parallels earlier actions by Trump over the border wall. While Trump does appear to be circumventing the decades-long working relationship between the White House and Congress over international arms sales, Friday’s action isn’t unprecedented. Four other administrations (Carter, Reagan, Bush 41, and Bush 43) have invoked this exemption. Still, we expect greater pushback this time around given the current political environment.
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Last year amid allegations of TDG earning excess profits on DoD contracts and a request by Rep. Ro Khanna (D-CA), the DoD Inspector General (IG) launched an investigation reviewing 47 spare parts purchased by the Defense Logistics Agency (DLA) and the Army during Jan 2015 and Jan 2017. The IG issued its report in Feb 2019 concluding that TDG made excess profits on 46 out of 47 parts and recommended TDG voluntarily refund $16.1M to the government since the company didn’t technically break the law. The House Committee on Oversight and Reform held a hearing on 5/15/19 and asked five witnesses to testify consisting of 1) Kevin Fahey, the Assistant Secretary of Defense for Acquisition; 2) Glenn Fine, the Acting IG for the DoD; 3) Theresa Hull, Assistant IG for Acquisitions for the DoD; 4) Kevin Stein, TDG president and CEO, and 5) Nick Howley, TDG executive chairman who attended but didn’t give a separate prepared remark.
At the 2019 Sea-Air-Space exposition last week, Navy acquisition head James Geurts voiced some concerns over the industrial base’s ability to sustain the accelerated production cadence of the Virginia Class submarine (VCS) program. Geurts noted delivery delays on Block IV submarines and the potential that this causes problems with the upcoming Columbia Class submarine (CCS), which he indicated is the Navy’s top priority. While we believe there are challenges the submarine industry needs to overcome, namely shortage of qualified workers, some of the issues that Geurts brought up appear to be gamesmanship in part to persuade Congress to provide more funding to both the VCS and CCS programs and also to motivate the private sector to improve its performance and make further investments. For instance, the expected 4-7mo delays on Block IV are against a 60-month start of construction to delivery timing vs. a 66-mo target under the previous Block III. In addition, we believe this delay won’t
TDG posted EPS (ex-items) of $4.21 vs. consensus of $3.96 and our $3.69E. Comparison isn’t that meaningful given the wide dispersion of estimates, we believe, driven by the inclusion or exclusion of ESL deal-related costs (e.g, we included all charges). Still, TDG saw strong top-line performance broadly across its three end markets especially at defense (+18% y/y) and comm A/M (+6% y/y) despite harder year-ago comps. And margins (ex charges) seem healthy. But TDG’s FY19 outlook felt a bit soft, driven in part by conservatism, slowing defense booking trends, and management’s lack of conviction on ESL’s margin cadence and pro forma growth trends by market (yes, it’s early). In a tough tape amid a sea of red, we’re not exactly surprised shares of TDG pared all their gains (+2%) earlier this morning and closed -1% somewhat ahead of the broader market.
The DoD Office of Inspector General completed its investigation into allegations that Acting SECDEF Patrick Shanahan improperly promoted BA and disparaged competitors (notably LMT) in violation of his ethics obligations. The investigation was prompted in part by Sen. Elizabeth Warren (D-MA) and media reports of alleged improprieties. The DoD OIG concluded none of the allegations were substantiated, and Shanahan fully complied with his ethics agreement in a 47-page report released on 4/25. This favorable outcome could enable President Trump to go ahead and formally nominate Shanahan for the full SECDEF post. There had been reports that Trump was planning to nominate Shanahan prior to the DoD OIG investigation. All else equal we would view that as a modest positive for the defense sector, if it were to matter at all.
Last week (4/9), one of Japan’s F-35A planes disappeared from radar over the Pacific Ocean after taking off from Misawa Air Base for a nighttime air combat training mission. The fighter was flown by Major Akinori Hosomi, an experienced pilot with 3,200 flight hours, 60 of which were accumulated in an F-35. Prior to losing contact, Major Hosomi told the other three F-35 pilots participating in the exercise to abort the training portion of the flight but gave no indication that he was experiencing problems, according to Japan’s Air Self-Defense Force (ASDF). None of the other three pilots saw the F-35 crash and ASDF noted good weather conditions. This fighter was the fifth F-35 delivered to ASDF and the first F-35 assembled at the Nagoya FACO facility by Mitsubishi Heavy Industries.
We are finally compelled to make some assumptions around the timing and magnitude of the impact of 737 MAX delivery delays using the information we have today. Though the factors underlying our assumptions are certain to change, for now we assume the MAX stays grounded until mid-June and deliveries start again in July. The net impact is ~$600M in lower 2019 OCF in our BA model and $6 out of our target price.
TDG completed its acquisition of ESL last Thursday (3/14) for $4.0B consisting of an estimated $3.7B in cash (at $122.50/share) and $273M of assumed net debt (now retired). Timing of the close was in line with expectations. TDG paid an implied EV/EBITDA multiple of 12x and EV/S multiple of 2x based on FY19 consensus EBITDA of $330M and sales of $2B, putting this deal at the high end of TDG’s target 9-12x range. That said, TDG is optimistic it can rationalize this “misunderstood” company and make operations leaner, more efficient, and more profitable. TDG recognizes ESL’s EBITDA margins won’t reach its corporate average of ~50%, but management expects significant improvement from the 14.1% ESL realized in FY18. We believe TDG is embolden by its success with the Kirkhill lab experiment (TDG bought Kirkhill from ESL last year).
We believe Delta Air Lines (DAL) is increasingly making aircraft purchase decisions based on the earnings potential it can generate from overhauling engines on the plane for other airlines. DAL has expressed enthusiasm for BA’s NMA (they did so again yesterday) noting an interest to be a launch customer. But we believe the likelihood of DAL buying the NMA may have been lessened by Rolls-Royce (RR) pulling its UltraFan engine offering from the NMA competition due to DAL’s focus on aftermarket work.
The Finnish Ministry of Defense issued a query potentially looking to acquire airborne electronic attack aircraft to replace its F-18 fleet as part of its HX Fighter Program competition. The DoD subsequently gave BA and the Navy the green light to offer the EA-18G Growler to Finland making that country the second international customer approved to buy Growlers. Australia is the only other Growler operator.
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