2023-07-25 16:35:17 ET
Summary
- The iShares U.S. Aerospace & Defense ETF has remained relatively unchanged due to the changing dynamics in the industry and supply chain complexities.
- However, the acquisition of Aerojet Rocketdyne by L3Harris could address some of these supply issues and also reduce costs for some key missile propulsion components.
- This explains my optimism for ITA, especially when comparing its valuation with a peer.
- However, given the concentration risks, I have a hold position while waiting for a better margin of entry.
Since the last time, I covered the iShares U.S. Aerospace & Defense ETF ( ITA ), its share price which currently reads $116.38 has suffered from a slight downside of -0.16% as pictured below. At that time I was bullish with a target of $126.6, with the main reason for my optimism being the higher degree of militarization in Eastern Europe and the opportunities it could represent for the large weapon manufacturers which are included in ITA's holdings as I will elaborate upon later.
ITA's stock slight downside compared to the Bullish thesis (seekingalpha.com)
In this thesis, my aim is to first understand why the upside I was expecting did not materialize and, second, to analyze the new dynamics at play in the defense industry following a possible merger between Aerojet Rocketdyne (NYSE: AJRD ) and L3Harris (NYSE: LHX ), as well as how this can play on ITA's value.
Too Much Focus on Demand
My last thesis entitled "ITA: Deserves Military Grade Valuations" was dated March 7 and came a few weeks after the first anniversary of Russia's unwanted presence in Ukraine which started on February 24, 2022. Therefore, it was written amid a background of military conflict plus heightened geopolitical tensions in East Asia around Taiwan. At that time, defense stocks were benefiting from investors' enthusiasm. Thus, ITA has gained nearly 17% during the last three years, while it was a different story for the S&P 500 whose performance was marked with volatility due to the Federal Reserve adopting a hawkish instance for tightening of monetary policy.
In these circumstances, the focus was on advanced weapons like the Javelin missile, co-developed by Raytheon Technologies ( RTX ) and Lockheed Martin ( LMT ), two of ITA's top holdings , and other military assets being requested by the Ukrainian defense forces to fight back against the invading force.
However, with so much focus on the demand side of things, few, including myself, paid attention to delivery, or the capability to supply. For this purpose, the production of such advanced weaponry involves different partners working together, resulting in a complex supply chain. This is partly exemplified by Raytheon or Lockheed sourcing critical propulsion components for the missiles they produce from Aerojet. This company is specialized in solid-fuel rocket motors, which are more stable than those using liquids, be it for use during ground combat operations, in the U.S. Navy's cruise chips, or its nuclear submarines. However, despite its prowess at producing cutting-edge military gear, Aerojet has a problem delivering on time, and, according to Raytheon's CEO, the company has become the " weak link" in the tactical missiles supply chain.
Now, together with program performance issues, and labor constraints, supply chain disruptions can indeed result in lower margins, according to the 2023 edition of PwC’s Global Aerospace and Defense.
To further confirm Aerojet's weakness from the financial perspective, I look at profitability and indeed, its EBITDA margins are among the lowest when compared to ITA's other holdings as charted below, which hints that it may be incurring higher costs of revenues as a result of possible management issues . Only Boeing scores lower, but then it has been gradually recovering as seen in pale brown while Aerojet's margins (orange chart) are on a net downtrend.
Now, Aerojet also supplies Lockheed, which forms part of the top U.S. defense contractors alongside Raytheon, implying that these two being supply-constrained could impact the nation's ability to deliver on its commitments to the Ukrainian army on time. Looking from a strategic perspective, this weakness in the supply of military hardware can adversely impact Ukraine's army performance on the ground in case it is not resolved.
Aerojet Acquisition is Positive for the Industry
To address the issue, a stronger Aerojet forming part of L3Harris ( profiled below) as part of a $4.7 billion all-in-cash deal could be beneficial for rocket manufacturers (including Boeing's ( BA ) Starliner spacecraft ), not only in terms of supply chain nimbleness but, also when considering the competition standpoint.
For this matter, the rocket motor supplier competes with Northrop Grumman ( NOC ) with the latter dominating the domestic market for such items, and, in case, Aerojet weakens further, its much larger competitor could end up benefiting from a monopoly which means abnormal pricing power.
seekingalpha.com
Consequently, in case the FTC gives the go-ahead to L3Harris for the acquisition, it would be good for the industry in general. To this end, L3Harris has recently complied with a request by the FTC to be a " merchant supplier ", which means that it will not favor any particular customer when it comes to supplying solid-rocket motors.
In this respect, one of the advantages of investing through ITA is that investors can gain exposure to several industry players at once, and, in this connection, it tracks the Dow Jones U.S. Select Aerospace & Defense Index, with the top twenty holdings illustrated below.
ITA Holdings as of July 23, 2023 (www.ishares.com)
Focusing on the six holdings I have been talking about up to now and whose weights are shaded in green above, they account for 54.03% of ITA's overall market cap. Therefore, with more competition leading to more innovation and more choices, these companies should be able to respond faster to additional demand, and, without being overstretched .
Valuing ITA Accordingly
Now factors like innovation and wider choice generally result in lower costs which in turn leads to more profits, as demand also remains elevated due to the Ukrainian conflict lingering on. To provide investors with an idea of potential profit gains, one can glance at the above-20% EBITDA margins of 3M Company ( MMM ), a commercial industrials play. Its margins are above those of the six defense plays in the table above.
Thus, with its holdings likely to increase margins, ITA deserves better valuations. To come up with a value, I make a comparison with the SPDR S&P Aerospace & Defense ETF ( XAR ) which is more equal-weighted and has only 23.93% of its weight dedicated to the six holdings as tabled below.
Table built using data from ITA and XAR as well as from Morningstar (www.morningstar.com)
Thinking aloud, the very structure of a defense market which is configured as an oligopoly means a high level of interdependence between different stakeholders. As a result, the supply chain has become more concentrated with an industrial and technological base that has been called upon to deliver increasingly sophisticated weaponry. In the same breath, Ukraine primarily requires land-based systems in the form of missiles. I think in this particular context, these six stocks should benefit more and ITA provides the most exposure to their stocks, at 54% which is more than double XAR's.
Consequently, the iShares ETF should be valued better in my view.
Thus, using XAR's higher Price-to-Earnings multiple of 22.79x , ITA's metric of 20.99x appears discounted, and adjusting accordingly, I come up with a target of $126.36 (22.79/20.99 x 116.38) based on the current share price of $116.38, which is about the same I provided in March.
XAR's Holdings (www.ssga.com)
However, this time around, the focus is more on risks.
The Risks and Way Forward
These pertain to some members of Congress trying to block the deal, with the most prominent one of them is Senator Elizabeth Warren, on grounds that it will lead to further concentration risks which should then adversely weigh on the Department of Defense's ability to fetch better pricing for military equipment.
However, others in Congress, plus the U.S. Chamber of Commerce are in favor of the deal and here, we can learn from the reasons why the FTC blocked an earlier bid made by Lockheed to acquire Aerojet in December 2020. The main reason provided for the rejection was that the bidder develops missile systems and the acquisition of one of its suppliers would stifle competition. However, this is not the case for L3Harris, which is an electronics company and not in the business of building missile systems or the boosters which launch them into space, which implies a limited probability of antitrust issues blocking the deal. On the contrary, it could be advantageous for the authorities as they endeavor to promote competition in solid rocket motors.
Still, bear in mind that as a highly concentrated cocktail of just 39 stocks, with more than 70% of its weight spread on the top ten of these, ITA comes with more volatility risks than the broader market, represented here by the SPDR S&P 500 ETF Trust ( SPY ).
Comparison with the broader market (seekingalpha.com)
Hence, in view of the above risks and till the deal is not finalized, I have a hold position on the ETF. In this respect, focusing on momentum indicators, the current RSI of 55.35 shows a slightly overbought position. Before that in May, the indicator dipped to the 40 level leading to a lower share price of around $110. This could again be the case in the weeks to come because some macroeconomic data pertaining to global manufacturing around the world, (including China and Europe) are unfavorable , while there is demand uncertainty in the U.S. For this purpose, many of ITA's holdings provide services to the commercial sector, namely for industrial machinery and aerospace, which are likely to be more vulnerable to normal economic cycles.
Finally, as this thesis has identified, there are prospects in the defense sector as a result of M&A activity, which should translate into margin gains for some of ITA's top holdings as a result of a nimbler supply chain and lower costs, but it is not the right time to invest.
For further details see:
ITA: Aerojet Acquisition By L3Harris Is Positive For The Defense Industry