Loading up on Booz

I struggle with earnings season. In one sense, I hate it. As I’ve tried to say from the start, the best way for an individual investor to make money on stocks is to think in terms of years, and not quarters.

But that’s not to say we should totally ignore earnings season. Every three months we get a glimpse into what is going on inside the large corporations we are investing in. I don’t believe we should overreact to what we learn, but very few companies are so well run that we can just totally tune out any and all developments.

In an Emersonian way, earnings season gives us a chance to check our priors, to see if the worldview we’ve used to select our stocks remains at least somewhat anchored to reality.

With that in mind, we are now more than halfway through defense earnings season. And there have been some interesting developments. Here are a few thoughts on what we have seen.

Disclosure: I’m not actively buying or selling any of these stocks right now. I don’t know if you should buy or sell any stock mentioned here. I do have plenty of some of these stocks in the current portfolio. So yeah, I’m talking my book.

The Edward Snowden redemption arc

At some point hopefully the primary word association tied to Booz Allen Hamilton will not be the Oliver Stone movie. (Don’t get me wrong, Joseph Gordon-Levitt and Shailene Woodley are fabulous in it.) For those who shy away from the company because of its ties to spy drama and the dark arts, you are missing a heck of a ride.

Who says defense stocks can’t be sexy? Booz Allen is up nearly 200% over the past five years, which is 120 percentage points better than the S&P 500. It was up more than 10% after earnings, in part because it beat expectations (and earnings were up 31% year over year). But also because of guidance that suggested the momentum can continue.

Booz Allen hiked its dividend by 8% and raised its full-year guidance range, and said it expected better-than-expected cash from operations. Headcount was up 8%. If you want to sound smart, follow headcount with these companies. Hiring is a great indication of where revenue is headed. Oh, and gross margin was 54%. Consulting/IT work tends to be profitable work, especially if your employees have clearances that make you hard to easily replace with a lower-cost bidder.

One of the things that has surprised investors over the past year is that the war in Ukraine, and what is happening in the Middle East, has not translated into defense stocks rocketing higher. (Well, it hasn’t surprised all investors.)

Defense hardware is a long ramp time business with pretty steady demand. The U.S. government assumes chaos and understands planes and tanks and bombers take years to develop and build. Chaos and war does reaffirm that position, but it does little to move the needle on sales or deliveries in the next quarter.

Defense IT, the so-called Beltway Bandits, is a shorter sales loop. We can see more of a reaction based on current events. And we still have the long-term trend of government outsourcing riding on top of it. This long-time holder continues to happily go along for the ride.

Prime beefs

Three months ago, I called General Dynamics the winner among defense primes for the third quarter. At the risk of repeating myself, that was even more true this time around. And for some less-than-great reasons.

Don’t get me wrong, General Dynamics had a fantastic quarter. The long-awaited Gulfstream ramp has arrived. Companies shamed during the Great Financial Crisis can only avoid buying new business jets for so long. The fleet is aging, and these execs are not going to be caught flying coach! Not only did General Dynamics beat estimates across the board, it also reported a strong book to bill and saw backlog up 5%.

We now have pretty strong visibility that suggests solid gains through 2026, yet GD continues to trade at an enterprise value (relative to earnings) that trails its peers. It also offers a cash flow yield north of 6% as of this writing.

But the real story among primes this quarter was Northrop Grumman laid an egg and Lockheed Martin barely bothered to show up. Lockheed first: The fourth quarter actually beat expectations, but ongoing F-35 issues led to putrid 2024 guidance.

For a year or so now, Lockheed has been telegraphing itself as an income play (and not a growth machine) through 2025 at least as R&D worked through the books and new platforms slowly come online. The F-35 is dragging its feet. The second half of 2023 teased us into thinking things might be ahead of schedule. They aren’t. This is still a fabulous company, but 2024 is what it is.

Over at Northrop, an expect profit turned into a loss due to a massive $1.55 billion charge related to its B-21 bomber. The B-21 contract was written nearly a decade ago, and the $700 million price tag per plane seems antiquated compared to current supply chain costs. Uncle Sam doesn’t care, and as a taxpayer we should be glad. But Northrop now expects to take a loss on the first five batches of B-21s delivered to the Pentagon.

But it isn’t just that one program. The Minuteman ballistic missile is on watch. Overall, the B-21 drama helped distract from less-than-stellar performances elsewhere, including space and mission systems.

Worth noting that even with the issues Northrop Grumman expects to grow free cash flow by more than 15% through 2026, delivering a cash flow yield that could reach 5%. That’s not General Dynamics great, but it isn’t a disaster. The company is fine and the B-21 will deliver… eventually. But blah.

Participation awards

I included RTX (the artist formerly known as Raytheon Technologies) in the Investing Unscripted portfolio contest not because it is my favorite aerospace stock. I don’t personally own any shares. But RTX was beaten and bruised by the embarrassing issues at its Pratt & Whitney engine unit last year. My guess is they navigate through the trouble a lot better than Boeing could, to use one example, and airlines have little to no alternatives. So RTX probably recovers what it lost in 2024?

The highlight of the quarter was Pratt’s surprisingly strong guidance, which would seemingly reinforce that idea. But the legacy Raytheon defense business was a disappointment, which is a surprise given the need to replenish missile stocks.

RTX is fine. Free cash flow is strong. I still have hope for that pick in the contest. But I also don’t have any more desire to own the stock now than I did a few months ago.

Over at L3 Harris, a stock I do own, things remain turbulent. LHX has done a lot of M&A of late, more than they likely wanted to. (You can’t control the timing of when good assets become available.) The quarter was a beat, but to be kind, it appears that given all of the integrations and complications they are being conservative when it comes to things like guidance.

I believe in this management team, and I am intrigued by the product mix and the ability to operate in the realm of the big primes without carrying all of their baggage. But that assumes they get the integration right. The quarter and commentary reinforced that there is a lot of work needed to turn potential into reality.

It could be an opportunity. It could end in tears. We’ll know eventually, but not today.

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