1. Northrop Grumman (NYSE: NOC), rated OVERWEIGHT by Sanford Bernstein
In January, the Pentagon said it would cut $78bn from its five-year budget, cancelling a host of military projects. This came as no surprise. Investors have been fretting for a while about US spending cuts as the ‘war on terror’ winds down and the war on deficits ramps up.
But what hasn’t been fully appreciated by Wall Street is how politically sensitive the defence industry is. Obviously, there’s the question of making sure soldiers are well-equipped. But the sector also employs thousands of scientists and engineers. In fact, it’s so technologically rich that it’s actually seeing extra government spending being allocated to priority areas such as unmanned aerial vehicles, covert surveillance and cyber-warfare.
That’s good for Northrop Grumman. The company is America’s third-largest defence contractor after Boeing and Lockheed Martin, providing equipment used in intelligence gathering, spy planes, missile systems, fighter jets, combat drones and cyber-security. What’s more, it sports a $43.7bn order book and a rock-solid balance sheet with a cash-neutral position. As a demonstration of its credentials, the firm won a $1.1bn contract in March to work on the Department of Homeland Security’s IT networks. This involves designing, building and maintaining infrastructure to provide classified data and voice and video services to more than 15,000 users nationwide.
Wall Street expects 2011 revenues of $27.6bn and underlying earnings per share (EPS) of $6.71, rising to $28.0bn and $7.14 in 2012. That puts the stock on a price/earnings (p/e) ratio of less than ten and a 3% yield. I would value the group on a nine times earnings before interest, tax and amortisation (EBITA) multiple. Adjusting for the $2.8bn pension deficit, you get a value of around $80 a share.
What are the risks? There are the usual headaches of dealing with governments, such as project delays, and the possibility of cuts to the $550bn defence budget. British investors also need to consider foreign-exchange fluctuations because the US represents about 90% of turnover. Yet Northrop is digging in the right spots. It is packed with game-changing sciences that should become ever-more important in wars. Second-quarter results are due out in late July. Sanford has a price target of $77.
Recommendation: Buy at $64
2. C&W Communications (LSE: CWC), rated a BUY by Deutsche Bank
The share price of Cable & Wireless Communications (CWC) dropped 10% last week after it shocked the City by warning of a prolonged downturn in one of its four major markets. But this looks like an over-reaction. Born out of Britain’s colonial past, CWC owns an eclectic mix of trophy assets across 38 overseas territories, linked by four regional hubs in Panama (32% of EBITDA), the Caribbean (26%), Macau (18%) and Monaco (24%). The firm’s bread-and-butter activities include fixed-line (1.3 million customers), broadband (0.5 million), mobile (4.7 million) and entertainment services. The problem is in the Caribbean, where its business is being hit by fewer tourists and the effect of this on domestic businesses. Revenues here fell 3% to $850m in the year to 31 March and EBITDA plunged 15% to $229m.
CEO Tony Rice thinks things will only get worse, with EBITDA set to fall by another 10%-20% to between $180m and $210m this year. While “there are signs of recovery in the Cayman Islands and in Barbados… the east Caribbean and Jamaica are still suffering”, he says.
But this is where it gets interesting. The US economy is recovering, and eventually tourists will return to the region’s golden white beaches and deep blue seas. Holiday-makers are already returning to Florida in their droves. If I’m right then this is exactly the time to snap up shares, especially as CWC’s other three divisions are doing nicely. Revenues from Macau jumped by 19% to $377m as Chinese gamblers flocked to new casinos. Monaco saw sales leap 10% to $605m, while Panama was flat. Overall, I estimate that 2011/2012 EBITDA should be around $860m on turnover of $2.4bn.
The group has just bought a 51% stake in Bahamas Telecommunications (BT), the country’s incumbent mobile operator, for $210m. After $60m of integration costs, cash profits are set to rise above $90m. Finally, the board has a three to five year plan to whittle the group down to a more manageable 15 to 20 territories, from the current 38. Disposal proceeds would be used to cut proforma net debt of $1.2bn (equating to twice proportional EBITDA), and continue to pay its dividend of eight cents a share.
Given all this, what is CWC worth on a sum-of-the-parts basis? Assuming there’s a rebound in the Caribbean, the firm could hit a sustainable EBITDA of $1bn. Based on an average through-cycle multiple of 6.5 – adjusting for the $85m pension deficit and minority stakes – that gives an intrinsic worth of around 55p a share. So at current levels there is even an outside chance of a private-equity house launching a bid for the group.
Of course, in the short term there is a great deal of execution risk relating to the turnaround, the integration of BT and the reshaping of the portfolio. The dividend could also be trimmed to conserve cash (although even if it is halved, there’s still a tasty 5% yield on offer). Lastly, for British investors, 86% of profits are denominated in currencies linked to the US dollar.
But the best time to invest is when there’s blood on the street. Rice seems to agree, as he has just bought 300,000 shares at 43p each. Deutsche has a target price of 74p.
Recommendation: Buy at 43p
Update: C&W Worldwide (LSE: CW)
I also believe that C&W’s sister company, C&W Worldwide, should get its ‘mojo’ back soon. This British-based telecoms company said it faced near-term headwinds from a declining legacy voice business, offset by impressive double-digit growth in its data-hosting arm. From my calculations, C&W is worth six times EBITDA, which, adjusting for net debt and pensions, delivers a fair value of more than 85p a share.
• Paul also writes the Precision Guided Investments newsletter. Call 020-7633 3634, or see www.moneyweek.com/PGI.
Disclosure: I own shares in both CWC and CW.