Kongsberg Gruppen: A Conflicting Investment Opportunity (OTCMKTS:NSKFF)

My Thesis for Kongsberg Gruppen ASA

An interesting yet disturbing piece of news I recently came across showed that the number of global conflicts in 2023 rose sharply over the previous year – by 28%, to be precise. While I’m not surprised that this would indeed be the case, just from reading daily news headlines, it does present an opportunity to invest in the business of war. Crass as that may seem, it’s a reality that war can be profitable.

That may be unpalatable to many investors, so this article is mainly addressed to those who don’t mind investing in war; in this case, using a relatively obscure (to retail investors in the U.S., that is) Norwegian defense contractor called Kongsberg Gruppen (OTCPK:NSKFF) (OTCPK:KBGGY) as a long-term vehicle of choice as we stand on the verge of what might very well be the most perfect storm from a global conflict standpoint. And that’s where my thesis arises from, as you’ll see in the next section.

About the Company

Over 200 years old, Kongsberg is a 50% Norwegian government-owned provider of high-end maritime, defense, aerospace, and digital technologies. This $11 billion enterprise primarily earns its living from maritime sales, which contribute about 50% of its total operating revenues per the latest report, but it originated as a weapons manufacturer for the Norwegian Armed Forces in the early 19th century, eventually being awarded a contract to supply the U.S. Army in 1893 with an improved version of the original Krag-Jorgensen bolt-action rifle. The company’s Defense & Aerospace segment is a very close second to Maritime, bringing in NOK 16 billion against the defense segment’s NOK 20 billion.

Today, the company has its fingers in multiple pies, still with a heavy tilt toward maritime but with defense racing to catch up, which is the key point of my thesis that this company is firmly on a growth path, and with greater profitability in sight because of the ongoing increases in defense spending.

First, let’s look at the numbers as they stood at the end of the fourth quarter of fiscal year 2023.

Highlights from the Q4 Presentation

In its Q4-23 report released earlier this month and linked above, the company crossed a significant top-line milestone of NOK 40 billion, or about $3.8 billion, in annual sales. That’s being driven by a growth rate of nearly 10% a year over the last decade, and one only needs to look at shorter and shorter timeframes to see that its current growth rate is stronger than ever. That’s one of the reasons I was very surprised to see that a significant player in the defense ecosystem of Europe had zero coverage on Seeking Alpha – thus, the opportunity.

Kongsberg had one of its best years in recent times. Contributing strongly to the major revenue milestone I mentioned, Q4 operating revenues came in at NOK 11.9 billion, with its largest segment – Maritime – posting an impressive 21% YoY growth rate. Its other segments grew even more strongly, albeit from smaller bases.

More relevant to my investment case is that defense and aero grew much faster at around 29%. It also has better margins, with an 18.2% EBITDA margin against maritime’s 12%. However, since the company records a significant amount of D&A and impairments, it’s best to look at the EBIT margins, which came in at 9.6% for maritime and an impressive 14.9% for defense and aero.

All of this information can be found in the Q4 presentation, so I’m not going to regurgitate what an investor is already likely to know or can quickly find. What I’d like to explore is the trajectory for the defense and aero segment and any potential upside that investors can hope to take advantage of. This, to me, is going to be the core growth engine for the new Kongsberg as it navigates its third century in existence.

Defense & Aerospace

The first thing I looked at was how much of the total order intake and backlog this segment was reporting. On a full-year basis, the system-wide figure of NOK 65.4 billion is heavily tilted toward the defense segment, which accounts for NOK 37.7 billion of that, or very close to 60%. In contrast, the maritime segment only accounted for NOK 22.4 billion, or 34%. Moving to the final quarter, notice that the intake for defense contributes a much higher 79% as of Q4, with maritime’s contribution dropping to 15%.

Why does that matter? It matters because defense and aero is slowly taking up the lion’s share of revenue contribution. Maritime brought in NOK 20 billion in operating revenue for the full year and NOK 5.6 billion for Q4, while defense only brought in NOK 16 billion but almost matched maritime over the last quarter with NOK 5 billion.

Further validating the importance of the defense and aero segment is the fact that it grew strongly over the FY20-FY21 period, then went into negative growth in FY21-FY22 before coming in strong once again in the FY-22-FY23 period (linked in the previous section.)

One of the reasons for that growth spurt in order intakes (previously called new orders) is the fact that the Norwegian government bumped its defense spending in 2021, some of that surge going to Kongsberg from a large missile order for the then-new fleet of F-35s, as well as strong intake from both Norway and Germany for submarine combat systems.

I’ll strengthen the case further. We can see below how Norway’s and Germany’s defense budgets have grown over the past decade.

Of note also was the extension of the very valuable framework agreement with the United States Army for Kongsberg to supply its Commonly Remotely Operated Weapon Stations, or CROWS. This land and sea remote weapons system or RWS is an obvious hit with the U.S. military, with supply numbers touching 18,000 units as of September 2023, and the company having signed its “fourth five-year indefinite delivery/ indefinite quantity (IDIQ) contract worth $1.4bn awarded in October 2022.” The framework agreement dates back to 2007, making this the 17th year running for that important defense revenue stream.

One sentence from the defense and aero segment in their FY-23 presentation really caught my eye:

Robust market activity and well positioned for substantial order intake going forward.

That’s putting it mildly, to say the least. With conflicts on the rise, as pointed out at the start of this article, and the fact that order intake for defense is surging for Kongsberg, it’s clear that this will be the biggest breadwinner for the company, and I see FY-24 possibly being year of the big transition.

Of course, maritime will ably support that with its steadier cadence, but it’s time for defense and aero to take centerstage.

Segment Profitability and Overall Shareholder Gains

I’ve always said that revenue growth can be a panacea for nearly all other problems, and that’s true for a defense contractor as much as a pet retailer, as outlined in my latest article on BARK, Inc. (BARK). Revenue growth is always a good thing, but only if the bulk of that makes it down to the bottom line, with excess earnings going back into shareholders’ hands in the form of equity, dividends, and capital appreciation from share buybacks.

To begin that assessment, let’s look at what kind of margins this 200-year-old company is putting up.

We’ve already seen a strong EBIT print in Q4/FY-24 at approximately 15% for both of those periods – and when you couple that with a high order intake and the equally strong backlog of NOK 65 billion as at the end of Q4-23, you’re looking at a very strong net income trajectory. This is supported by the fact that Kongsberg expects more than 40% of that backlog to be delivered over the next two years, with the rest expected the year after. That’s a pretty strong three-year guidance, and it gives investors a fair amount of visibility into revenues as well as earnings.

Loosely translating that into expected EBIT, at a 15% margin we’re looking at NOK 9.8 billion in pre-tax profits. It’s also important to note that this 15% is actually down from the year-ago margin of 18.7%, but that’s due to the project mix having shifted over the past year. Still, it continues to be a significant driver of overall EBIT margins for the company, which is in the 10% to 12% range.

The other major positive I see in terms of greater visibility into the company’s revenue and, therefore, its profitability, is the book-to-bill ratio. While the maritime segment reported suboptimal book-to-bill ratios of 0.86 for the quarter and 1.11 for the full year, mainly due to the lower order intake for newbuilds, defense recorded a quarterly bill-to-book ratio of 4.95, which is extremely encouraging, to say the least.

To elaborate, book-to-bill is the relationship between order intake and reported revenue. Not only does it offer visibility into forward revenues, but it also acts as an indicator of the larger defense market and where it’s headed. For Kongsberg, that means the order intake for the fourth quarter is nearly five times reported revenue, and we already know that over 40% of that will be recorded in the coming eight quarters of FY-24 and FY-25.

With a 15% EBIT margin, this segment is going to lift the company’s entire profitability profile over the next few years. As an investor, that should get you excited, but it also comes at a premium, as we’ll see below

Kongsberg Valuation

According to ValueInvesting.io, various DCF and other valuation models agree on one thing – the stock is expensive no matter how you look at it.

The problem is, the data in the table above tells me very little about the real potential of the company. Stocks can often look expensive when using conventional valuation metrics (hence the investor’s need to obsessively engage with them in all their prolific plurality); that one table literally gives me 10 good reasons why NOT to buy the stock – but here I am touting a Buy – a Strong Buy a that! Why?

The answer, in my opinion, is two-fold.

On the one side, the market is generally wary of bubbles, and although Kongsberg’s performance this past year has been phenomenal, to say the least, in no way does it represent a bubble. All it does is represent a major shift in the need for every developed country – and emerging nation, for that matter – to defend its borders – at all costs. Military spending is clearly on the rise, and as a key player in Europe, across which countries are aggressively increasing their collective budgets, Kongsberg is one of the direct beneficiaries of that increased spending, and government contracts are typically long-lived, as we saw from the extension of the CROWS agreement.

On the other side is the real value growth of an investment made now in Kongsberg – even though valuations are high. I’m the first to admit that the 22x EV to forward EBIT multiple the company is currently trading makes it look like it’s approaching the valuations of Nvidia (NVDA) with a 27x multiple or Microsoft (MSFT) at 29x forward EBIT, but if you consider the strong revenue visibility over the next several years and the strong forward EBIT growth rate of +23%, it doesn’t look expensive. At a current Enterprise Value of roughly NOK 120 billion and FY-28 EBIT projected at NOK 9.25 billion using a very, very conservative 15% EBIT growth rate over the next five years, you’d be paying less than 13 times FY-28 EBIT. This is against a current EBIT growth rate of nearly 40% YoY (NOK 4.6 billion from NOK 3.3 billion in the prior period) across the company. The 25% EBIT growth rate for defense and aero will dampen some of that EBIT growth, but 13 times the five-year forward EBIT projection is a steal.

If you were to pin me down for a fair value estimate, I’d say an EV/EBIT multiple of around 20x would be par for the course. Woodward Inc. (WWD), a U.S. aerospace contractor, trades at around that level, with Elbit Systems (ESLT) trading even higher. On FY-28 forward EBIT estimates of NOK 9.25 billion, as calculated above, I’d peg Kongsberg at about NOK 185 in Enterprise Value, representing an upside potential of about 55%. In ADR terms, that would translate to roughly $97 per ADR.

Sure, I’d love this stock even more at a cheaper price, so you might want to either dollar cost average into a larger position or look for opportune dips in market sentiment. However, even at the current parent/ADR levels of NOK 670 and $63, this is worth a look.

The Bonus Investment Opportunity

The additional opportunity here is that the stock (the ADR, to be precise), let alone the company, is barely known by U.S. retail investors. Just looking at the company’s follower base of under 500 on Seeking Alpha tells me that this company needs more exposure to retail investors in the United States. That also creates another problem – illiquidity for the ADRs. Just look at the average volume, per Yahoo! Finance, of the parent listing versus the ADRs – nearly 182k for KOG.OL against 634 for the OTC equivalent.

However, you can see that volumes are trending nicely for the ADRs. Notice the upward volume trend since the start of the year. That tells me the relatively small pool of current investors are likely increasing their positions significantly based on positive expectations (volume trending up even before earnings) that were then validated by Kongsberg’s latest quarterly/full-year report.

In my opinion, a lot of this positive sentiment can be attributed to the gains in defense and aero, more than anything. It also implies that on the profitability front, defense’s stronger EBIT profile will offer a sizeable boost to overall net income for the group. Of course, the drop in EBIT due to the changing mix of projects handled by the segment is a negative, but, as we saw earlier, it’s still several percentage points higher than the system-wide average.

That’s where the future upside comes from, in my opinion. Yes, the stock might look expensive at this level, but if you compare it to a U.S. peer like Woodward Inc. or even an Israeli counterpart like Elbit Systems Ltd. – both of which have at least a few thousand followers on Seeking Alpha – you’ll see that its valuation is quite comparable. In other words, it’s trading at levels that are par for the course.

And this aspect really pops out when you recognize the fact that the company is no slouch when it comes to bottom-line and core profitability.

I specifically point to the company’s strong cash flows and return on equity. You want to see your investment keep building equity in an ideal scenario, and Kongsberg has been able to keep that needle moving quite well. Here’s what we’re looking at on that front:

All things considered, my take is that the growth in the company’s defense segment is what drives future upside at this point in time, and I don’t believe that’s fully priced in. The reason might be the weak retail investor interest in the U.S. for this ADR, but that’s growing stronger, and I believe if more investors look at the hidden opportunity, trading volumes will rise, and we’ll have better liquidity in the future, so you can build a relatively large position without worrying about having a clear exit plan. You should always have that plan in place, of course, but you’ll be able to do it with increasingly larger positions as investor awareness and trading volumes grow. As long as Kongsberg can deliver consistent revenue growth over the next two to three years, this ADR could give you quite a handsome return.

On the flip side is the risk that this won’t happen. I’m not seeing any significant risks to the business or its metrics, per se, but a gradual subsiding of global conflict (trying very hard to keep a straight face here) is a material risk to the company’s ability to keep posting strong revenue growth over the next few decades.

Fortunately (or unfortunately, for those involved in such conflicts), I don’t see that happening in the near to medium term. There’s a tremendous amount of acted-on as well as pent-up geopolitical tension in the world right now. Governments are wound tight, which shows in their defense budget increases. Various sources revealed last year that we hit an all-time high of $2.24 trillion in worldwide military expenditures, increasing by a significant 13% for Europe.

I don’t see that spending being curtailed for the foreseeable future. To me, that’s a good-enough indication of the robust downside protection that comes with companies operating in the defense space. I’m relatively new to Seeking Alpha, so I’m not sure too many people will see this article and appreciate the investment opportunity here. My only hope is that SA stalwarts in the aerospace and defense domain, like Dhierin Bechai, whose work I very much admire, pick up this idea and spread it to their followers. More market participation means higher trading volumes, leading to more liquidity, possibly less volatility, and a growing interest in this highly regarded European defense contractor.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.