Last week (6/19), the House passed H.R. 2740, a package of four FY20 appropriation bills including defense. The vote was 226-203, largely along party lines with seven Democrats opposing the bill including Rep. Alexandria Ocasio-Cortez (D-NY), who we believe may be emerging as a prominent voice against robust defense budgets. For the DoD, the House appropriations bill provided $690B for the defense discretionary budget comprising $622B for base and $68B for OCO. This level of funding falls below both the President’s budget request and the Senate NDAA mark-up of $718B, and the bill transferred $98B of otherwise base budget requirements tucked in OCO back to the base budget. The White House has already threatened to veto the bill.
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Heading into this year’s air show, we were expecting a total of ~400 orders and commitments between Airbus (~300) and Boeing (~100). We weren’t surprised by the tepid order activity so far: Airbus announced a total of 112 orders and commitments (O&Cs), while Boeing booked only 10 orders (excluding UAL’s firm order of 20 E-175s). In comparison to the last four air shows (2015-18), Airbus averaged 105 O&Cs and Boeing averaged 96 O&Cs on Day 1 (see Exhibit 1 on page 2). We continue to believe order activity will be muted at the Paris Air Show and throughout the year with 2019 B:B likely to come in well below 1x.
On Saturday (6/8), WSJ broke news that UTX and RTN are in talks to merge. Sunday afternoon (6/9), both companies confirmed media reports and provided some more specifics. Under the all-stock deal, RTN shareholders will receive 2.3348 shares of the post-spin UTX, resulting in RTN shareholders owning 43% of the combined entity. UTX and RTN expect the merger to close in 1H20 after UTX spins off Otis and Carrier, also slated for 1H20. The resulting company, called Raytheon Technologies, will be a massive A&D conglomerate with a pro forma market cap of ~$120-130B (by our math), pro forma 2019 sales of ~$74B, and pro forma net debt of ~$26B. UTX CEO Greg Hayes will lead RT while RTN CEO Tom Kennedy becomes executive chairman for two years post-close before turning over that role to Greg Hayes. We don’t expect much regulator opposition, nor do we expect other bidders to emerge to drive up the price given RTN’s size and importance to the DoD (i.e., foreign bidders need not apply).
Bombardier announced plans in early May to consolidate its aerospace assets into one integrated business unit called Bombardier Aviation. Under this reorganization, the company’s aviation business would focus on business and regional jets, namely its Global, Challenger, Learjet, and CRJ brands. Bombardier will retain its nose-to-tail aerostructures capabilities in Montreal, Mexico, and Red Oak but divest its Belfast and Morocco facilities. Yesterday (6/5), Bombardier disclosed discussions it’s currently having with Mitsubishi Heavy Industries (MHI) over the sale of its CRJ program given recent media reports.
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.
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
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.
RTN reported 1Q19 EPS of $2.77 widely ahead of our $2.50E and consensus of $2.47. Upside vs. our estimates came from better-than-expected margins (+$0.07/sh), sales (+$0.04/sh), and other non-operating items (+$0.16/sh). However, much of the call today (4/25/19) focused around margin weakness at Missile Systems (MS) that caused shares of RTN to sell off as much as 6% this morning before paring back some losses to close -4%. Sentiment is clearly negative for RTN, and we believe the stock will remain under pressure until RTN can demonstrate a path toward MS margin recovery similar to 2014 when IDS repeatedly missed expectations.
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.
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