Leonardo DRS: Strong Business As Always, But High Valuation (NASDAQ:DRS)

Since my last article, titled “Leonardo DRS: Favorable Tailwinds, But Maybe It’s Time To Cash Out (Rating Downgrade),” Leonardo DRS, Inc. (NASDAQ:DRS) has experienced further growth, proving itself to be a robust company that is progressively emerging among its competitors. This success is not only attributed to its unique technology and strong backlog, but is also favored by the geopolitical landscape and the rise in global military spending, which is fueling revenue.

In this article, I do a brief analysis of recent developments and I focus on analyzing Leonardo’s current valuation, the key concern at the moment from my point of view. Despite the stock’s momentum, driven by favorable tailwinds and the optimism surrounding the defense sector, I maintain the belief that Leonardo may have surpassed its fair value. Consequently, this could diminish the stock’s attractiveness to potential investors.

Starting from the good news

As I have emphasized in my previous articles on the company, one aspect that consistently impresses me is the gradual improvement of DRS’s cutting-edge technologies and the increasing recognition it receives from major players in the sector. Another crucial point, as highlighted in my previous analyses, is the pivotal role US defense supplies play for DRS; in fact, 62% of its sales face no competition.

In this regard, exciting news was released on January 10, where the company announced a $3 billion contract for designing an electric propulsion system for Columbia-class submarines.

Leonardo DRS was chosen by General Dynamics Electric Boat and the U.S. Navy to design and manufacture the permanent magnet main propulsion electric motor, the propulsion motor drives, switchgear, and the propulsion controls – the heart of the Columbia Electric Drive Propulsion System. These are key components of the primary propulsion system of the next-generation ballistic missile submarine fleet.

According to Bill Lynn, CEO of Leonardo DRS:

This award highlights Leonardo DRS as an agile and trusted partner for the U.S. Navy and General Dynamics Electric Boat, having now been awarded contracts to supply our state-of-the-art electric propulsion components through chipset 12 for the Columbia-class program…

(Source: Leonardo DRS Investors)

On January 23rd, another positive announcement was made: DRS revealed the launch of the new Stretto line of high-precision lasers, specifically designed for applications in quantum information science.

Stretto lasers are designed to bring the reliability and adaptability required for cutting-edge quantum applications… this design enables scientific discovery while facilitating scalability in quantum information science applications and ensuring seamless OEM integration.

(Source: Leonardo DRS News Release)

This illustrates how DRS has once again excelled not only in terms of revenue and backlog but also in showcasing innovation in cutting-edge technology.

The defense sector might be overvalued

However, an essential point to consider is the overall valuation of companies in the defense sector. The sector’s rally last year was fueled by escalating geopolitical tensions, leading to a notable increase in military spending.

This is evident in the performances of the iShares U.S. Aerospace & Defense ETF (ITA) and SPDR S&P Aerospace & Defense ETF (XAR) ETFs, returning +9.41% and +13.63%, respectively, in just one year.

The United States and European NATO countries have predetermined defense spending targets for the coming years, providing specific guidelines to the supplying companies. A crucial characteristic of these companies is their ability to predict revenue well in advance, along with a reliable estimate of margins and cash flow, thanks to long-term government contracts and guidelines. Consequently, when a government announces increased military spending and the financing of aid packages, the augmented expenditure is swiftly priced into these companies’ valuations.

Looking ahead, unless significant new conflict scenarios emerge, it seems unlikely that NATO countries (considering DRS exclusively sells to them) will decide to further augment their defense budget targets. Therefore, it seems reasonable to anticipate that the prices of defense stocks are more likely to decline than to continue rising.

Indeed, this is a variable to take into great consideration: generally, shares within a particular sector move in tandem, both in ascent and descent. While I doubt that defense shares will experience a rapid decline in the short to medium term-given the numerous factors supporting their growth on the stock market-there is a diminished likelihood compared to last year’s sustained growth. This poses a challenge for companies like DRS, especially when they are above their fair value.

The valuation

Finally, the evaluation represents the most significant challenge for DRS. I have revisited my estimates using the DCF model, adjusting some data based on the newly received orders and the projections and results presented in the Q3FY23 quarterly report on November 2nd.

I increased the revenue data, anticipating an optimistic year-on-year growth of 5%. Additionally, I changed the adjusted EBITDA margin, noting a consistently positive trend in recent years. I see no reason to believe that this positive trend would change in the next few years (I estimated 2024-2026), given the anticipated increase in defense spending.

However, the model indicates a fair value lower than the current price, with a potential downside of approximately 8.6%. In comparison to today’s price of $19.37, the company’s NPV per share would be around $17.70. This adjustment would bring the PE ratio to a more reasonable x28, and the EV/EBITDA to x17, aligning closer to the sector average. Despite this, the Price Sales ratio at x1.8 remains a favorable point for DRS.

The final valuation is not bullish; in fact, from my perspective, as explained in the article, there are several factors that could contribute to a decline in the stock rather than further appreciation. However, it’s worth underlining that, while I maintain my Hold rating for now, I am very optimistic about the company’s long-term prospects. Therefore, I believe that any price correction could present an excellent opportunity for long-term investment.