As Confederate General Robert E. Lee said, “It is well that war is so terrible, otherwise we should grow too fond of it.”
Thus conceding that war is terrible, does it make us a bunch of Milo Minderbinders if we invest in a military contractor?
Are we indeed the spiritual(-ly bankrupt) offspring of Joseph Heller’s mess officer/war profiteer from Catch-22, who’s described by one critic as both a “prophet of profit” and the “embodiment of evil”?
The debate over war profiteering has percolated in this country since the 1860s, when “shoddy millionaires” both North and South were subjected to “scurrilous charges” of making money over the dead bodies of brave soldiers.
I don’t begrudge you the moral high ground if in this particular ethical dilemma you steer clear of weapons stocks.
But what if we frame the debate in terms of “defense” rather than war?
(Though, granted, that may be a distinction without a difference in this age of American Empire and perpetual armed conflict, with a proven interventionist on her way to the White House).
And what if that military contractor also does a lot of work for civilian aerospace projects, public and private?
These nuances, and a little self-awareness, make a question of pure amorality a little more complex.
In the absence of clarity, I suggest we fall back on value and opportunity.
Thinking as an investor, my priorities are to buy low, sell high, and build wealth for the long term.
I’ll let God sort everything else out.
We first discussed Orbital ATK Inc (NYSE:OA) on August 15, with regard to its selection by NASA to participate in a contest to design prototype deep-space habitats for a planned mission to Mars.
To reiterate, Orbital ATK is the result of the February 9, 2015, merger of Orbital Sciences Corp. and Alliant Techsystems.
Through its Flight Systems, Defense Systems and Space Systems groups, Orbital researches, designs, develops, and manufactures rockets, rocket motors, satellites and spacecraft.
With a market cap of $4.25 billion, Orbital shares are up about 14% since the merger, outperforming the Russell 2000 and the S&P 500 by 2.6% and 6.4%, respectively.
As I noted last week, before the market opened on August 10, Orbital management announced that it would restate its fiscal 2015 financial results and delay the announcement of fiscal 2016 second-quarter earnings.
That prompted a sell-off of nearly 25%.
On August 9, the stock closed at $88.77, 6.5% below its 52-week high of $94.92. It gapped lower to $78.52 at the August 10 open and traded as low as $67.04.
It’s now trading around $73.
That’s one helluva correction — a crash, even.
Is there some fundamental reason to justify this sell-off?
Based on management’s explanation for the restatement, my answer is no. And that means there’s strong value and significant opportunity in Orbital shares.
CFO Garrett Pierce explained the accounting errors during Orbital’s preliminary second-quarter earnings conference call.
According to Pierce, the problems relate to a contract awarded to predecessor Alliant Techsystems in 2012 to produce small-caliber ammunition for the U.S. Army and other military services and to operate and maintain the Lake City ammunition plant on behalf of the U.S. government.
The fixed-price contract from 2012–2022 has a total value of approximately $2.3 billion. It currently generates $240–250 million in annual revenue for Orbital — about 5% of the company’s total sales.
Explained Pierce, “As an earlier Army ammo contract was winding down, this new program moved into high-rate production in fiscal year 2015. In order to provide the best possible value to our military, the company had to price the new contract aggressively.”
Part of its aggressive approach included an effort to contain costs. But Orbital’s Lake City operation “was unable to reduce the production cost far enough for the contract to be profitable.
“At the same time,” Pierce added, “the implementation of a new enterprise resource planning system in 2014 and other challenges obscured actual cost trends until our recent review.”
Orbital management forecasts that the associated accounting errors will result in a pretax operating loss of approximately $400 million and an after-tax loss of about $250 million over the 10-year life of the Lake City contract.
The company will realize this loss in fiscal 2015, the first year of large-scale production under the contract.
Management doesn’t expect the adjustment to “result in material changes to [its] earnings guidance for the balance of 2016 or in future years.”
It will, however, reduce cash flow by about $25–30 million in 2016 and 2017 and by similar amounts out to 2022, when the contract expires.
The bottom line? Based on the midpoints of management’s guidance figures:
- Revenue is now expected to be 3% lower.
- Operating margin is expected to be 50 basis points higher.
- Free cash flow is expected to be $50 million (or 17%) lower.
- Earnings per share are expected to be slightly higher by a few cents.
And now some context: Orbital reported $110 million in free cash flow in the second quarter of 2016 alone.
A 25% sell-off — or a $1 billion market cap wipeout — is way overdone.
Orbital is a mid-to-high-single-digits revenue growth company. That revenue, lumpy as it may be, is reliable because it’s based on government contracts.
It continues to win new work — innovative stuff like the Mars habitat and the five-segment solid rocket boosters for NASA’s Space Launch System (SLS). Orbital is also working on more prosaic projects such as the future ground-based strategic deterrent to replace the Minuteman missile.
And operating expenses as a percentage of revenue continue to decline. That means management is efficient.
Based on the midpoint of management’s adjusted 2016, Orbital shares are now trading at just 13.36 times earnings, 24% below its recent high multiple of 17.57.
The dividend yield is 1.7% ($1.20 per share annually), with solid dividend growth potential ahead.
If you can stomach it, Orbital ATK offers a compelling combination of value and opportunity.
Upticks, Downticks
- The Russell 2000 small-cap index added 6.95 points, or 0.5%, last week, to finish at 1,236.77, 4.8% below its all-time high of 1,296.00 on June 23, 2015.
- According to IHS Markit, the United States now spends about $569 billion per year on defense, most of which goes to operations, maintenance and personnel. That’s down from $587 billion in 2014, but it’s still about 38% more than the next five countries — China ($190.9 billion), the United Kingdom ($66.5 billion), Russia ($53.2 billion), France ($52.7 billion), and India ($49.7 billion) — combined.
- The Federal Reserve said industrial production rose by 0.7% in July, the biggest increase since November 2014. Industrial production rose by 0.4% in June. For manufacturing, output rose by 0.5%, the biggest jump in more than a year.
- According to Zolo, a Canadian real estate brokerage that tracks MLS home sales in real time and reports prices as an average versus a “benchmark,” Vancouver has an average home price of $1.1 million. That’s down 20.7% over the last 28 days and 24.5% over the last three months. There were three home sales in West Vancouver during the first two weeks of August, down 94% from 52 during the same period a year ago. July sales were down to 44, compared with 80 in July 2015, following a June decrease to 74 from 102 a year ago.
- Real hourly wages increased 0.4% in July, more than reversing the 0.2% decline in June. Wages are up 2%, compared to 12 months ago.
- Rent increased 3.8% compared to a year ago, and medical care prices were up 4.1%.
- Seth Rogen and collaborator Evan Goldberg are writing the pilot script for a new “half-hour comedy television series about the Singularity for FX,” Rogen revealed on the August 11 edition of the Nerdist podcast.