Global Aerospace/Defense Group
The View From Wall Street:What Investors Think of the
Defense Sector
Presented by:Pierre A. ChaoManaging DirectorGlobal Aerospace/Defense Group(212) [email protected]
National Defense Industrial Association2003 Munitions Executive Summit
Falls Church, VA
February 12, 2003
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Global Aerospace/Defense Group
Disclosuresl Investors should assume that CSFB is seeking or will seek investment banking
or other services from the covered companies.
l For important disclosure information regarding the Firm's rating system andpotential conflicts of interest, please email: [email protected] or call(877) 291-2683.
l 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.
l 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.
l CSFBC and/or its affiliates expect to receive or intend to seek investment banking related compensation from the subjectcompany (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.
l As of the date of this report, CSFBC makes a market in the securities of the subject company (BEAV, GRMN, LDSH).
l 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 past12 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 orintend 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 itsforeign affiliates, CSFB is not making certain disclosures required by NASD Rule 2711 and NYSE Rule 472 until the datethat it actually complies with these requirements, which will be no later than November 6, 2002.
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Global Aerospace/Defense Group
Defense Investment Dynamics
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Global Aerospace/Defense Group
l Investors approach the stock market with a set of “mental models”- composed of rules of thumb, images and mental tools
l Mental models are necessary to sort through and process a hugeamount of information within a short time frame
l Mental models are generatedl Internally by investors - experience, trial and error,
“conventional wisdom”l Externally by the aerospace/defense industry - raw data,
management, investor relations, communications team via thepress
A Way of Approaching the Stock MarketMental Models
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Global Aerospace/Defense Group
l The commercial aerospace industry is a deeply cyclical industry - proneto booms and busts
l Defense companies are “sexy utilities” - they are stable, never missnumbers and predictable
l Boeing is a commercial aerospace company (corollaries: never invest inBoeing during a downturn in commercial aircraft orders or when R&Das a percentage of sales is going up)
l The defense budget is in decline
MENTAL MODELS ARE OFTEN SLOW TO CHANGE!
Any of These Sound Familiar?Mental Models
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Global Aerospace/Defense Group
Relative Stock PerformanceDefense Investment Environment
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
0
100
200
300
400
500
600
700
800
900
12/3
1/90
10/2
5/91
5/19
/92
12/0
9/92
7/02
/93
1/24
/94
8/17
/94
3/10
/95
10/0
2/95
4/24
/96
11/1
3/96
6/09
/97
12/3
0/97
7/24
/98
2/17
/99
9/09
/99
3/31
/00
10/2
3/00
5/17
/01
12/1
3/01
7/10
/02
1/31
/03
Defense
Defense Electronics
S&P500
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Global Aerospace/Defense Group
Relative Stock PerformanceDefense Investment Environment
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
What’s BeenGoing On?
0
100
200
300
400
500
600
700
800
900
12/3
1/90
10/2
5/91
5/19
/92
12/0
9/92
7/02
/93
1/24
/94
8/17
/94
3/10
/95
10/0
2/95
4/24
/96
11/1
3/96
6/09
/97
12/3
0/97
7/24
/98
2/17
/99
9/09
/99
3/31
/00
10/2
3/00
5/17
/01
12/1
3/01
7/10
/02
1/31
/03
Defense
Defense Electronics
S&P500
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Global Aerospace/Defense Group
Defense Investment Environment
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
0
50
100
150
200
250
300
12/3
1/99
2/18
/00
4/07
/00
5/26
/00
7/14
/00
9/01
/00
10/2
0/00
12/0
8/00
1/26
/01
3/16
/01
5/04
/01
6/22
/01
8/10
/01
9/28
/01
11/1
6/01
1/04
/02
3/01
/02
4/19
/02
6/07
/02
7/26
/02
9/13
/02
11/0
1/02
Defense
Defense Electronics
S&P500
Aggressive Growth/Mo 3.5% 5.4% 6.2% 7.5% 11.6% 11.6% Growth 14.9 14.5 16.7 17.8 20.3 22.7 GARP 22.5 22.4 22.4 23.5 20.3 20.4 Value 37.8 37.7 33.3 30.9 27.6 24.5 Index 21.3% 20.0% 21.5% 20.3% 20.2% 20.8%
8.5x6.9x 10.2x 11.1x 8.9x
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Global Aerospace/Defense Group
20
30
40
50
60
70
80
9/01
/200
0
10/19/20
00
12/06/20
00
1/25
/200
1
3/14
/200
1
5/01
/200
1
6/18
/200
1
8/03
/200
1
9/26
/200
1
11/12/20
01
12/31/20
01
2/19
/200
2
4/08
/200
2
5/23
/200
2
7/11
/200
2
8/27
/200
2
10/14/20
02
11/29/20
02
2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q02 3Q021.6% 2.5% 3.4% 3.6% 2.9% 19.9% 24.3% 20.8% 23.6% 28.4% Mo/Aggressive9.1% 16.0% 18.2% 20.2% 19.0% 20.7% 22.1% 22.6% 25.2% 26.2% Growth39.0% 34.6% 35.9% 37.0% 41.1% 29.7% 21.2% 24.1% 24.2% 22.4% GARP36.4% 33.0% 27.7% 23.1% 18.2% 12.5% 14.6% 14.6% 10.6% 10.4% Value13.8% 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%
ATK (Alliant Techsystems)
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Global Aerospace/Defense Group
Lockheed Martin
20
30
40
50
60
70
80
9/01
/200
0
10/16/20
00
11/28/20
00
1/11
/200
1
2/26
/200
1
4/09
/200
1
5/22
/200
1
7/05
/200
1
8/16
/200
1
10/04/20
01
11/15/20
01
12/31/20
01
2/13
/200
2
3/28
/200
2
5/10
/200
2
6/24
/200
2
8/06
/200
2
9/18
/200
2
10/30/20
02
1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q020.5% 2.5% 2.6% 2.4% 2.5% 2.9% 4.5% 4.7% 4.0% 5.4% Mo/Aggressive9.8% 8.9% 7.1% 7.8% 10.3% 11.0% 12.6% 14.8% 16.5% 17.9% Growth10.3% 10.4% 10.3% 10.2% 10.9% 12.1% 13.2% 15.6% 16.8% 16.6% GARP45.7% 46.6% 51.1% 49.7% 46.3% 44.4% 39.9% 33.8% 33.1% 31.0% Value33.7% 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%
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Global Aerospace/Defense Group
L-3 Communications
20
25
30
35
40
45
50
55
60
65
70
9/01
/200
0
10/16/20
00
11/28/20
00
1/11
/200
1
2/26
/200
1
4/09
/200
1
5/22
/200
1
7/05
/200
1
8/16
/200
1
10/04/20
01
11/15/20
01
12/31/20
01
2/13
/200
2
3/28
/200
2
5/10
/200
2
6/24
/200
2
8/06
/200
2
9/18
/200
2
10/30/20
02
1Q00 2Q00 3Q00 4Q00 1Q01 2Q01 3Q01 4Q01 1Q02 2Q024.8% 9.9% 13.8% 14.6% 17.0% 19.5% 23.4% 18.4% 15.3% 17.2% Mo/Aggressive36.5% 38.2% 33.7% 34.6% 37.1% 34.7% 28.4% 28.3% 32.5% 27.1% Growth26.7% 23.8% 23.0% 24.6% 22.3% 23.6% 27.2% 27.7% 23.0% 24.0% GARP23.0% 18.7% 18.9% 15.4% 10.5% 10.8% 10.2% 14.2% 16.7% 12.1% Value8.9% 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%
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Global Aerospace/Defense Group
Mental Models Used By Aggressive Growth/MoDefense Investment Environment
l Acceleration is key
l 6.5% growth FY02 over FY01, 18.8% FY03 over FY02
l What about FY04 over FY03?
l Focus on P/E and GAAP EPS
l Renters, not owners
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Global Aerospace/Defense Group
l 75% of Investor Polled Said They Used:u Discounted Cash Flow of Free Cash Flow Analysis oru Price to EBITDA (proxy for cash flow) Analysis oru Cash Earnings (proxy for cash flow) Analysis or ROIC
l Used to be 100%
Investors Still Prizes the Industry for its Cash FlowsDefense Investment Environment
P/ E
Other
EV /EBITDA
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Global Aerospace/Defense Group
Mental Models Used By Aggressive Growth/MoDefense Investment Environment
lFocus on P/E and GAAP EPS
l PENSIONS PENSIONS PENSIONS
l LMT 2003 GAAP EPS = $1.72 vs. economic =$3.42
l RTN 2003 GAAP EPS = $1.65 vs. economic = $2.17
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Global Aerospace/Defense Group
Defense Investment Environment
lWhat do other/the rest of the investorsthink?
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Global Aerospace/Defense Group
Defense Investment Environmentl Do you perceive the aerospace/defense industry to be a growth industry?
Source: MSDW survey
No
Yes
No
Yes
Source: CSFB survey
1999 2000
No
YesSource: CSFB survey
2002
• “Long term no”• “In an upcycle now, but no reason to grow equal to GDP over time”
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Global Aerospace/Defense Group
Defense Investment Environmentl Are you invested in the defense sector now?
Source: CSFB survey
No
Yes
• “Valuations too high”
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Global Aerospace/Defense Group
Defense Investment Environment
l What are the alternative investments when you consider thedefense sector?
Source: CSFB survey
Entire Market
Transportation
Technology
Commercial Aero
Capital goods/Industrial
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Global Aerospace/Defense Group
Defense Investment Environmentl Why are you invested in the sector?
Source: CSFB survey
"Insurance"Consolidation
Attract valuation
Stability/visibility
Defense Cycle
• “To make money!!!!”
Earnings Growth
Cash Flow
Earnings Stability2000
2002
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Global Aerospace/Defense Group
Defense Investment Environment
l Why would you sell your defense investment?
Source: CSFB survey
Program cancelledOther investment
Loss of mgmt credibility
Change in strategy
Program/Earnings miscues
Budget outlook/Political
Valuation/Price
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Global Aerospace/Defense Group
Investors Prize the Industry for its StabilityDefense Investment Environment
l What is more important to you: top-line growth or consistency of earnings?
Growth
ConsistencySource: MSDW survey
2002
1999
“Predictability of source andlevel of earnings, as opposed tosmoothness”
Growth
Consistency
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Global Aerospace/Defense Group
Defense Investment Environment
l What is more important, growth or return on capital?
Source: CSFB survey
Growth
Return on Cap
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Global Aerospace/Defense Group
Yes
Mixed
Yes
No
Investor Confidence Rebuildingl 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”
Source: CSFB survey
Yes
NoSource: MSDW survey
1999
2002
2000
“Getting better”
Defense Investment Environment
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And Government Policy is an Issuel Do you believe the defense industry earns appropriate marginsfor the risk taken?
Source: CSFB survey
Yes
No
2002
2000 “Yes – given the capital required”“Not many industries where R&D isfunded by customer”“Closed market, rarely losemoney…generate cash at minimal risk”
“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”
Yes
No
Defense Investment Environment
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Global Aerospace/Defense Group
And Government Policy is an Issue (2)l Do you believe the defense industry is healthy?
Source: CSFB survey
No
Yes
NO – “Industry still needs to deleverage” “The length of the procurement process too long, hurts the industry” “Should always attract capital”
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”
Defense Investment Environment
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Defense Investment Environment
lKey Questions:
l Future growth rates?
l Impact of Iraqi War?
l What is the five year case?
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Leveraging the Financial Markets “Financial Jujitsu”
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Global Aerospace/Defense Group
u How does the Munitions Buying Community use anunderstanding of the financial motivations of its supplierbase to further DoD goals:
u Technology innovation
u Assurance of supply
u Best value
u On time, on budget
Financial Jujitsu
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Global Aerospace/Defense Group
u Tie rewards that mean something to the industry toperformance goals
u Munitions – technology/program milestonesBuyers - on time delivery
- cost performance- innovation
u 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)
Financial Jujitsu
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Global Aerospace/Defense Group
u Use rewards/penalties that make financial sense, are fair and attractive to futureinvestment environment
u Tie return to cost of capitalu 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)
u A more nuanced system that takes into account past performance
A B CLow Risk CoC + 3% CoC + 2% CoC +0%Medium CoC + 5% CoC + 4% CoC +2%High CoC + 8% CoC + 7% CoC +5%
Financial Jujitsu
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Global Aerospace/Defense Group
u Fix the “throw aways” that don’t impact policy goals butare important to industry
u Paid cost rules
u Facilities as a determinant of margin rates
u Progress payments
u Etc. (see Defense Science Board study)
Financial Jujitsu
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Global Aerospace/Defense Group
u “Out of the box acquisition mechanisms” for “out of thebox ideas”
- Prize money (to kick start technology)
- Venture investment (to kick start technology)
- Leasing
- Real options (to price surge capacity)
Financial Jujitsu
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Global Aerospace/Defense Group
u You need a spectrum of management techniques for theindustrial base
u Look to the product cycle
Financial Jujitsu
Last of Breed Legacy Future(non-guided missiles) (1st Gen PGMs) (PGMs)
- preserve suppliers - balance competition - competition- accept monopolies? - shrink supplier base - look wide- leverage support - look offshore - innovation- manage capital - returns - investment
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Global Aerospace/Defense Group
Creating Value is NOT aZero-Sum Game
Companies Employees
Shareholders
Government
A healthy industry is able to attract investment/shareholders,lowering cost of capital, enabling it to invest more in R&D andattract talent, and be a better contributor to national security