Northrop Grumman Corporation: How Defense Budget Will Fare In 2014?

Defense stocks have performed like champions so far this year with the group up 52 percent, which is well ahead of the 38 percent average return for commercial aerospace stocks and more than the S&P's 25 percent return.

Investors have forgiven a lack of top-line growth and instead focused on margin and cash flow, both of which appear to be holding up remarkably well despite sales pressure.

Entering 2013, the defense sequester reduction was supposed to be $54.7 billion to the fiscal 2013 budget. When all was said and done, the actual cut was $31 billion (through the passage of the ATRA, a revision in OMB calculation methods, and by rescinding prior year budgeted funds).

For fiscal 2014, the Ryan-Murray budget conference will similarly lessen the blow from sequestration (much like the ATRA legislation in early 2013).

[Related -Lockheed Martin Corporation (NYSE:LMT): How A Small Budget Deal Impacts Defense Contractors?]

Deutsche Bank analyst Myles Walton said the budget deal creates some foundational stability for both fiscal 2014 and fiscal 2015. The fiscal 2014 budget remains under a continuing resolution that is tied to the sequestered levels of fiscal 2013 ($497 billion top-line ex OCO).

However, the above level is still about $19 billion above the sequester-required base budget funding level of $478 billion. The budget conference committee chaired by Congressman Ryan and Senator Murray found a compromise that at least put the fiscal 2014 on equal footing with fiscal 2013 and similarly holds the line in 2015.

[Related -General Dynamics Corporation (GD) : Short-Term Uncertainty, Long-Term Opportunity?]

Based on Walton's bottom-up revenue estimates, consensus sales estimates for large defense contractors appear to be inclusive of no major relief from sequestration over the next couple of years.

Given the relatively small size of the mini-deal, the impact to sales should be negligible for 2014 and about low-single-digit upside to 2015 estimates. Meanwhile, the contractors are not standing still in the face of budgetary pressure and continue to find ways to keep costs down well in advance of revenue declines, which has up till now translated into margin expansion and growth in cash per share.

Defense companies on average trade at just over 13 times forward EPS, which is 3 points higher than the 10 times the group traded at the start of 2013 and 4 turns higher versus beginning of 2012. Relative to the S&P 500, the defense group trades at just a 12 percent discount, versus 19 percent discount at the start of 2013 and a 22 percent discount at the beginning of 2012.

Walton noted that the relatively strong recovery in defense multiples, coupled with more modest EPS growth, means investors should remain more selective in the group.

In terms of particular stocks, Huntington Ingalls Industries Inc (NYSE:HII) and Northrop Grumman Corporation (NYSE:NOC) are the best performers gaining 100 percent and 68 percent, respectively, this year. Relatively, General Dynamics (NYSE:GD) is the "worst" rising 31 percent. Limiting downside among defense stocks are the plethora of options available to companies thanks to low gross debt levels and strong free cash flow, as well as excellent cost control (driving positive cumulative catch up adjustments), and below-market valuation.

What new scrutiny of life insurance captives means for advisers

As regulators scrutinize life insurers' use of “captive” entities — subsidiaries that reinsure blocks of existing business — advisers may need to rethink the way they evaluate the carriers they work with.

Life insurance companies set up captives to which they shift blocks of insurance policy business. These captives can be set up within the U.S. or offshore, in locations such as Bermuda or the Cayman Islands. Having a reinsurance captive means that the carrier can hold fewer assets to back claims that have been pushed off to the subsidiary.

Captives have been the subject of criticism recently by both the Securities and Exchange Commission and state insurance regulators. The SEC has sent letters to a handful of major insurers, asking about the captives and the ramifications if insurance regulators barred their usage, according to a Dec. 29 story in The Wall Street Journal.

New York State Financial Services Superintendent Ben Lawsky also has voiced criticism, based on the argument that carriers' use of captives allows them to carry smaller capital cushions to protect policyholders.

After creating the “captive,” an insurer “diverts the reserves that it had previously set aside to pay policyholders to other purposes, since the reserve and collateral requirements for the captive shell company are typically lower,” Mr. Lawsky wrote in a June report on the practice, which he dubbed “shadow insurance.” Poor disclosures behind the captives and their financial condition, as well as “artificially rosy capital buffers” for the carriers using the vehicles were among the regulator's chief criticisms of the practice.

“Shadow insurance could leave insurance companies on the hook for losses at their more weakly capitalized shell companies,” Mr. Lawsky noted in the report.

Advisers and broker-dealer executives, meanwhile, are in a tough spot. The idea of working with an insurer whose risk-based capital ratio isn't as strong as it appears — or even working with an insurer that liberally pours existing business into offshore entities — isn't exactly palatable. Getting the information needed to make such assessments of insurers, however, is far from easy.

“The whole idea of captive reinsurers was intended to obfuscate,” said Lawrence J. Rybka, chief executive of ValMark Securities Inc. “The practice is so widespread that if you said you wouldn't do business with [insurers that use captives], you wouldn't have anyone to do business with.”

Indeed, even researchers who dig through carriers' financial statements say that finding any details on the captives is difficult.

“The access to the captives' financials is almost nonexistent,” said David Paul, principal at Alirt Insurance Research. “We have to look at the balance sheets in order to make any kind of in-depth! comment on these, and we haven't been able to in most cases.” He noted that onshore captives issue statutory statements, but those companies account for a small portion of the overall captive universe.

Rather than poring through carriers' risk-sharing agreements, advisers might want to rethink the way they evaluate the life insurance companies they work with.

Mr. Rybka recommends looking past the flashiness of the product and its features and instead taking a closer look at the issuing company — the actual entity issuing the contract and not just the parent — as well as the financial strength of that entity.

He also suggested that advisers consider whether life insurance is a core operation of the issuing company. Parent companies that aren't as committed to the life or annuity business might feel fine about spinning off their life insurance businesses and captives to another buyer that doesn't prioritize the policyholders.

Mr. Paul noted that carriers' use of captives is just one issue to look at when it comes to advisers' evaluating their carriers. To understand the companies, their goals and their commitment to the business, it makes sense to examine quarterly and annual financial statements, as well as to sit in on the earnings calls.

“Management is broadcasting to the investment community about their plans, which may be diametrically opposed to what they tell the distribution,” said Mr. Paul. “Don't try to figure out some arcane thing about the captive, but look at what they say about the company's direction over the next five to 10 years.”