“Penny Defense Stocks” teased by The Casey Report

by Travis Johnson, Stock Gumshoe | May 17, 2017 3:30 pm

Which smaller contractors are being hinted at by E.B. Tucker as the foundation for the next wave of giant military contractors?

“These 4 “Penny Defense[1] Stocks” Are Primed to Soar on… The Pentagon’s Trillion-Dollar Spending Jackpot”

That’s the promise made by the new ads for E.B. Tucker[2]’s Casey[3] Report, which is pitching the stocks that they think will become the “new ‘Military Industrial Complex'” as they grow from small-cap size to compete with the megacaps like Lockheed Martin and Boeing.

So what are the stocks? Well, the temptation to riches that they dangle is intended to get you to subscribe to their newsletter, at $149 a year. Maybe you’ll like it, maybe you won’t… but let’s go through the clues they drop, see if we can ID those stocks for you, and then you can make a decision about the newsletter (and about those stocks) without the lure of mystery and secrecy swaying your thoughts.

The basic idea is that some of these little stocks will soar because of massive increases in military spending, creating returns like the crazy 55,000% returns that early investors made in Electric Boat (now General Dynamics) during World War II. I don’t know what specific time frame they’re using, but the giant defense contractors have generally all done quite well in the more recent past, too — General Dynamics is again among the best, with a 1,700% gain since the mid-90s, but even relative slowpoke Raytheon is up 400% during that time period, roughly matching the S&P 500, and Boeing and Lockheed both beat the market handily over those 20+ years.

Here’s how Tucker puts it:

“… they’re on the cusp of becoming the new “Military Industrial Complex.”

“The future Boeings, Raytheons, and Lockheeds.

“… we’re on the verge of major explosive military developments, including…

“Catalyst #1: NATO’s $100 Billion Spending Boom

“Catalyst #2: The $500 Billion Global Space Wars

“Catalyst #3: America’s Trillion-Dollar Nuclear Upgrade

“Catalyst #4: The Thousand-Ship Naval Fleet Buildup”

A lot of that is based on expectations for what President Trump will do to the defense budget, since he has come out of the gate with a big push to increase defense spending — I have no idea how that will play once Congress starts looking at the budget, but presumably there will be winners and losers.

What, then, are the small cap stocks that Tucker thinks will be winners?

Well, before we get there, probably the most interesting point made in the ad is that the Feds are being pushed to use smaller contractors with more efficient high-tech products over the traditional over-engineered or high-cost products from the big defense contractors — and that this is being pushed because of a legal ruling last Fall. Here’s how he hints at that:

“You see, just one week before the election, a federal court passed a historic ruling.

“A legal ruling that could put BILLIONS in cash into the accounts of very small military tech companies…

“And enrich investors who scoop up their shares before the Pentagon budget deadline, on June 30.”

And then he goes into more detail — apparently Palantir, the big data[4] firm cofounded by Silicon Valley billionaire VC guy (and Trump advisor) Peter Thiel[5], lost out to a more expensive and lower quality product from Boeing when it came to some kind of Army contract, and that led to a legal fight. Here’s more from Tucker:

“… the Army never gave Palantir the time of day, cutting it out of the bidding race. And went with Boeing instead.

“The outraged Theil went to war in what Fortune called “a crazy battle to clean up the military procurement swamp.”

“The billionaire saw an even bigger opportunity, much like when he sided with the Trump campaign:

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“An opportunity to open the doors for innovative tech to disrupt the military.

“And get this: He won….

“The federal court ruled in Palantir’s favor using an obscure law called the FASA Act…

“Which states that in contract bids the government should favor commercial firms…

“Innovative companies that get the job done cheaper and more efficiently….

“Never before has this ruling been applied to the military, where the big defense giants almost always win.

“As Bloomberg[6] reports, ‘it could change the way federal agencies do business, widening the base of eligible contractors.'”

I hadn’t followed this story, so that’s interesting to see — that Bloomberg article is here[7], if you’re curious about following up, and the more recent Fortune article, which goes much deeper into the story, is here[8]. Both are worth a read.

So what are those four stocks? We’ll try to run through them quickly, assuming the Thinkolator is up to the task… here are our first clues:

“One of these produces the shuttle boosters for space rockets, including Elon Musk[9]’s famous ‘Space X.’

“In fact, without this technology, the entire project would literally not ‘get off the ground.'”

Space X is still private, of course (as is Jeff Bezos’ Blue Origin — you know you’ve really arrived as a billionaire when you can start your own space program), but there are subcontractors, apparently, that everyone space project needs.

More clues:

“It already designs and manufacturers propulsion systems for the government, including the…

Army
Navy
Air Force
NASA
Missile Defense Agency

“These systems are necessary to launch any rocket into space. Without it, nothing would reach past the stratosphere.”

This must be little Aerojet Rocketdyne Holdings (AJRD) — a fairly small company, with a market cap of $1.5 billion or so, but not one that has been shut out of military procurement as far as I can tell. They’ve been making propulsion systems for jets, missiles and rockets since WWII, and have been a part of every mission in the US space program since Apollo 11 reached the moon. They’ve been through a few transactions and name changes over the years, but what remains is really just the scaled-down propulsion systems from Aerojet and Rocketdyne that both used to be hidden inside large conglomerates (GenCorp and United Technologies).

I don’t know specifically how they’ll do, but analysts are predicting about 85 cents in earnings per share this year, rising to $1.04 in 2018 and $1.25 in 2019, so that’s a decent amount of growth and the stock, at 24X current-year earnings, is fairly expensive to reflect that growth. I don’t know a lot about the company otherwise, they have a decent balance sheet for an industrial company, with manageable debt, and the consolidation of Aerojet and Rocketdyne seems to have helped them to keep revenue growth going.

Next?

“Another is a little-known company that just invented the most advanced unmanned aerial system in the world. One that’s capable of traveling nearly at the speed of sound!

“At $3 million apiece, orders for this cutting-edge technology are already rolling in. All told, $1 billion in orders this year is in the cards, something that will launch this $7 stock to explosive new heights.”

Sounds interesting. How about some more details?

“My research suggests the biggest winner will be one tiny $7-a-share company now known as “the rising star of the Third Offset.”

“Because it’s building top-secret weapons capable of maintaining a tech advantage over Russia[10] and China[11].

“One of these is now recognized by defense experts as…

“The World’s Most Advanced Drone… Made in America” ….

“It travels at near Mach speed – over 690 miles per hour….

“It can also:

“Approximate a fighter jet’s capability to conduct high-g-force maneuvers.

“Fly 1,500 nautical miles in a combat radius.

“Launch and land without runways.

“Carry a 500-pound weapons payload – sufficient for two GBU-39 small diameter bombs, or up to four Hellfire missiles.

“No other drone in existence, anywhere in the world, even comes close to this sort of power!”

And apparently this new drone is also a lot cheaper than the Reaper drones[12] the Air Force has been using. More from the ad:

“The Air Force spends, on average, $12 million for Reaper Drones….

“The world’s most advanced drone goes for a mere $3 million price tag – one-quarter of the price.

“In fact, just a single contract would nearly DOUBLE the market cap of this tiny company.”

So who is it? Thinkolator sez we’re looking at Kratos Defense and Security (KTOS), which has been a favorite pitch target for newsletters for a few years now. This spiel from the Casey ad is very similar to a recent Motley Fool[13] article about Kratos’ new drone program, in case you’d like another perspective.

Kratos pleased investors with its latest quarterly report, which was better than expected (they’re still not making money, but they’re coming closer), so it’s not a $7 stock anymore — it’s back to being a $9 stock. They don’t have bucketloads of orders for this new drone, but they are small enough that IF they get big orders, that would have a substantial impact — annual revenue is less than $700 million, so a few hundred million would certainly be felt.

The company might post a profit this year, at least on a non-GAAP basis (not counting stock options[14], etc.), and analysts think they’ll earn 34 cents (adjusted again) next year, so the stock is still priced for growth — that’s still 28X next year’s earnings, but those same analysts expect 30% earnings growth in 2019 (there are only a few analysts following this stock, so these guesses should get even more skepticism than the typical analyst estimate).

I’ve been a bit skeptical of KTOS over the years, they’ve done a lot of jumping around and acquiring small companies as they look to “roll up” into a bigger operation, but they’ve not yet been able to get the financials to consistently look promising… that skepticism might come because they’ve been teased by folks at Money Map Press[15] for eight years now with similar stories of anticipated greatness, so if you’re coming new to this story perhaps you can give it a fresher eye than I can (I also wrote some about Kratos earlier this year when Dr. Kent Moors[16] was touting them because of their tangential connection to “Railgun” weapons programs).

What else?

“Trump’s major priority is rebuilding America’s nuclear arsenal.

“The first item on the agenda is our ICB missile system – a system of 450 nuclear missiles that are breaking down, worn, and in desperate need of an upgrade.

“The Air Force now wants to do exactly that. And this company is one of the few that can make it happen.

“In fact, it’s virtually the ‘go-to’ choice.

“By October 1, the Air Force is scheduled to award a new contract.

“A contract that will mean a full overhaul, including new missiles, launchers, and control systems!

“The price tag is steep at $85 billion… three-and-a-half times bigger than McDonald’s revenue. And that’s just for starters…

“According to Defense Industry Daily, the cost of rebuilding these missiles will be $350 BILLION over 10 years. And $1 TRILLION over 30 years.

“In order to contain costs, a ‘penny defense stock’ will likely win. And this tiny company is the best for the job – hands down.”

So… how small is it?

“… this company has a mere $1 billion market cap.

“But winning this contract would launch it to the likes of Boeing, Lockheed, and big defense blue chips.”

I don’t know if this program is really going to go to someone new or not, that seems a bit of a stretch — but, like most military programs, it will probably include the work of dozens of companies beyond the prime contractors. Boeing built the Minuteman ICBMs in the first place, and they, along with Lockheed Margin and Northrop Grumman, have been involved with the contracts to maintain and upgrade them over the past thirty or forty years, along with other major contractors like BAE Systems.

So no, a $1 billion company is not about to get an $85 billion contract to replace or rehab all the ICBMs… but it could certainly get a piece of that. Lots of companies work on missiles of various types, including Parker Hannifin (PH)[17], Woodward (WWD)[18], Orbital ATK [19](OA), and I suppose you could even include companies that are primarily in aviation support like AAR (AIR) and Triumph (TGI).

So I don’t have a definitive answer, but the two smaller companies I would initially look at because of their part in the next ICBM upgrade, which is the contracting process that’s starting with the next award on October 1[20] (but will, of course, take decades), would probably be Aeroject Rocketdyne (AJRD), which we already looked at (and which is roughly a $1 billion company), or Orbital ATK (OA), which is far larger at about $5 billion but is still much smaller than the lead contractors who are likely to win. It’s possible I’ve missed another $1 billion player that perhaps could be the Casey Report[21] pick here, so feel free to suggest that if you’ve been following the sector.

How about another one? I thought you’d never ask!

“A Laser Cannon… On Every Navy Ship?

“Some even call it ‘World War 3’s main weapon.’

“It can obliterate drones, helicopters, and patrol boats – in a single shot.

“It can be fired with a video game-like controller.

“And it costs $1 per shot.”

OK, I was kidding about “another one” there — that’s just more hype for the “laser cannon” that Kratos was part of, so this is a continuation of that pitch for KTOS. If you’re interested in the laser cannon, this skeptical article about the science[22] is worth a read, and the military has continued to pursue more powerful laser cannons (like the Northrop Grumman project the Motley Fool wrote about here[23]).

OK, so now we’re REALLY moving on… what other small cap is ready to soar?

“Trump is calling for the largest Navy in U.S. history.

“Popular Mechanics reports he’ll need 6,419 new ships to meet this promise.

“AP calls it the ‘biggest naval expansion since the Cold War’…

“The Hill estimates a whopping $165 billion price tag…”

OK, I think we can all now acknowledge that we shouldn’t cite Trump’s claims of “largest” or “biggest” with a straight face, since he applies those adjectives to every idea that pops into his Twitter feed, but yes, he has spoken in the past about wanting to upgrade the Navy with new ships.

And to some degree, that means it’s a nuclear story — which is what’s being pitched here. First, some comparisons between nuclear powerplants for ships and nuclear powerplants that generate electricity on land:

“In the U.S., we have 100 nuclear reactors producing 20% of our energy needs.

“Next up is France with 58 reactors, followed by Japan[24] with 43.

“We consume more nuclear than every other country in the world – hands down.

“Now get this:

“The Navy beats all of America – with a total of 103 plants!

“All 11 of our aircraft carriers are powered by nuclear reactors.

“And every single one of our 75 submarines is nuclear-powered.”

There used to be a bunch of nuclear-powered cruisers as well, though I think all of those are now decommissioned, and onboard nuclear reactors are obviously different and far smaller than the nuclear power plants that are used to generate electricity on land, but it is true that refueling those vessels and building reactors for new submarines or aircraft carriers is a business of meaningful size. So what’s the stock? More hinting:

“As we undergo a massive naval expansion unlike anything seen in decades… or perhaps ever…

“We’ll see a massive boom in nuclear reactors…

“And there’s one – and only one – way to cash in:

“One ‘penny defense stock’ that builds these mini-reactors for the Navy.

“… it’s the sole contractor for the ‘Nuclear Navy’ ….

“In 2016, it won $3.1 billion in Navy contracts… just for supplying fuel and parts!

“So imagine the kind of money on the line with the Navy’s massive new fleet expansion.

“Each one…

“Requiring brand-new reactors…

“Needing new components and maintenance…

“At a price tag of $100 million!”

That’s the nuclear services company BWX Technologies (BWXT)[25], which did indeed win $3.1 billion in naval contracts for reactor components and fuel, as announced here[26]. They say that their subsidiary, Nuclear Fuel Services, has been the sole manufacturer of nuclear fuel for the US Navy’s aircraft carriers and submarines since 1964, so, again, this isn’t a little upstart trying to make its way into the procurement system — but with 50 years of sole contractor status you’d imagine that their business is probably pretty safe as long as the number of nuclear ships doesn’t decline (they only need refueling once a decade or so, so funding can certainly be bumpy if there are no new projects).

They just got another burst of funding in “contract options” from the Navy last month, so there is certainly revenue coming in, but I’m not sure how BWX structures its contracts or how much a revenue boost helps. They were routinely posting annual revenue of over $3 billion five years ago, and the company at that time was half the size it is now, despite the fact that revenue has dropped to $1.5 billion — so they’ve clearly improved their margins, but I don’t know how or why (maybe the falling uranium[27] price helped, but the big cuts weren’t to cost of goods, they were in SG&A and R&D), or whether they will maintain those better margins if the revenue bumps back up.

Analysts see BWXT earning $1.99 per share this year, then $2.20 and $2.49 in the following years, so that’s decent 10% earnings growth and a slightly expensive forward PE of 22 or so, perhaps not unreasonable for a company that might surprise with its growth over the next decade if the nuclear navy really gets a big boost, but this is also a stock that has risen 25% since the election so some of that optimism is certainly priced in… whether it’s all priced in or not, well, you can make that call. It is, after all, your money.

The stock I’ve been pulled to whenever one talks about expanding the navy is Huntington Ingalls (HII), which is not as small (market cap about $9 billion), but is really the “big ticket” contractor if President Trump decides he needs a much bigger naval fleet (he campaigned on increasing the fleet from ~270 vessels to 350) — and really, Presidents tend to love aircraft carriers, despite the fact that they lost some of their luster as the Cold War disappeared.

HII also got a pop after the election, but it has come back down a bit in the past couple months as the Trump budget talk has started to become actual plans that impact actual programs. HII comes out better than some because Trump’s budget boosts the number of ships they were expected to build by one (from the eight planned by Obama to nine), but, as we’ve seen in the past with government contractors, you never know when a Trump Tweet could move the stock price by 10% one way or another — and Trump’s campaign calls for a 12th aircraft carrier, which would probably be big news for HII, haven’t made it into the proposed budgets as far as I can tell. I’ve been thinking about this one on and off for a few years and haven’t ever bought any shares, so it’s not exactly a red-hot idea, but, well, it came to mind… so I share.

That leaves us, in case you’re keeping track, with three stocks teased by the Casey folks — Aerojet Rocketdyne (AJRD)[28], Kratos (KTOS), and BWX Technologies (BWXT). Throw on HII if you’re interested in a growing Navy, though it wasn’t part of the ad, and that’s not a bad cross-section of smaller defense contractors who specialize in various aspects of the military industrial complex. I don’t own any of them and can’t claim any expertise, but they’re all valued more or less as you might expect — a little bit expensive as we start a new administration that has promised spending boosts for the military, but probably not ridiculously expensive as long as their pet projects don’t face the budgetary chopping block when we get into the hash of actual budget debates in Congress.

Any of them sound exciting to you? Have others you’d like to throw out for the Gumshoe Faithful to consider? Just toss ’em on the pile with a comment below… thanks!

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