CAE - PPA: Defense Does Not Come Cheap

2023-11-20 23:52:06 ET

Summary

• Defense sector consistently outperforms SP500.
• Geopolitical events lead to increased NATO budgets.
• Defense stocks are expensive, with high PE ratios and modest EPS growth.

The defense sector has consistently outperformed the SP500

Geopolitical events have resulted in increased NATO budgets

Defense stocks are not cheap at 23x PE vs 13% EPS growth

Summary

The Invesco Aerospace & Defense ETF ( PPA ) is a diversified portfolio of 52 companies that specialize in designing and building military defense systems primarily for the USA and NATO. The aerospace and defense sector is usually resistant to economic cycles, with defense budgets rarely declining. Since the Ukraine invasion, there has been an increase in spending, which is likely to continue for many years. The stocks in the fund are rarely cheap and have outperformed the SP500 ( SPX ) since inception.

Defense Spending

The focus of the fund is on high-tech military systems, with key exposure in RTX ( RTX ), Lockheed Martin ( LMT ), Northrop Grumman ( NOC ), and Boeing ( BA ), which also have relevant civilian operations. Defense spending is generally inelastic to changes in GDP growth. Moreover, due to geopolitical events, defense spending is likely to enter a high growth phase.

NATO countries had pledged to spend 2% of their GDP on defense, but they rarely met this target until the Ukraine invasion. However, the situation is changing rapidly, not only to replace the equipment and systems that are being supplied to Ukraine but also to build up forces. According to one source, NATO is expected to increase spending by US$1 trillion over the next five years. ( Source )

Performance

The fund has beaten the SP500 and many peers since its inception in 2005 and also since the start of the rate hiking cycle and the Ukraine invasion in 2022. This helps demonstrate the resilient nature of the sector as well as the impact of geopolitical events.

Portfolio Upside

I analyzed the consensus price targets for 37 stocks, which account for 95% of the AUM. Based on the results, I found that the potential upside for YE24 is 10% at an implied target PE of 26x. Among the companies analyzed, KBR ( KBR ), an engineering services firm, has the highest potential gain of 31%, followed by CAE ( CAE ), a simulation company, with a potential gain of 27%.

Revenue and Margins

I analyzed the revenue growth and EBITDA margins of the funds holding using consensus estimates. The table below shows that the ETF has a consistent and respectable 8% revenue growth rate, with margins improving over time. BA is a unique case as its margins have recovered from nearly zero to 10% in YE25. Axon ( AXON ), the manufacturer of Tasers, is experiencing high growth and improving margins.

EPS Growth

According to consensus estimates, the fund has a weighted EPS growth rate of 13% for the YE24-25 period. The growth rate for YE25 is expected to be 21%, influenced by recovering companies such as Boeing ( BA ) and General Electric ( GE ). However, LMT seems to be a cause for concern, with a projected -1% EPS for YE24.

Valuation

I performed an analysis of the fund's valuation using the relative PE to EPS growth or PEG exercise. Generally, a PEG ratio of 1x or less is considered inexpensive. However, the fund's weighted PEG is 2x when comparing YE24 PE to YE24-25 EPS growth, which I believe is expensive. Please note that I excluded BA and Spirit Aero ( SPR ) from the calculation due to their abnormal EPS growth rates.

Concussion

I Rate PPA a Hold. While the fund and defense sector have shown higher returns than the SP500, it seems that the market has already factored in the growth and counter-cyclical benefits into the share price. In a risk-on-market scenario with the possibility of the end of the Fed rate cycle and potential rate cuts in YE24, the defensive nature of the fund may not be able to keep up with the broader market.

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