Defense Stocks: Advance or Retreat?

Lockheed Martin will kick off the sector's earnings season on Apr. 22, and analysts expect "respectable bottom-line gains"

With the media spotlight focused on the carnage in the financial sector and a slowing U.S. economy, it's easy to forget that U.S. companies still have attractive opportunities elsewhere. Case in point: Demand for infrastructure remains fairly robust in many economies around the globe, and aerospace and defense companies are among those that continue to benefit from that trend.

The boon from oil prices over $110 per barrel isn't limited to energy companies but is also creating more business for the aerospace industry as fuel costs continue to spur demand to replace old airplanes with new, more fuel-efficient models. That, plus ongoing strength in U.S. defense spending, is driving optimism about first-quarter earnings for aerospace and defense companies. Lockheed Martin (LMT), scheduled to report quarterly results on Apr. 22, will kick off the sector's earnings season.

"Defense spending is more or less on the same trend— mid-single-digit growth with some very respectable bottom-line gains," says Howard Rubel, an analyst at Jefferies (JEF) in New York.

Warning from Northrop Grumman

Troy Lahr, an analyst at Stifel Nicolaus (SF) in St. Louis, says he expects to see solid growth and some modest improvement in profit margins. "We're maybe another two years away from peak defense spending, so [companies] should have a pretty good run rate for the next couple of quarters," he says.

A notable exception is Northrop Grumman (NOC), the only company so far to pre-announce a major blip during the first three months of the year. On Apr. 15, it warned investors that it would take a pretax charge of $320 million to $340 million, or 61¢ to 69¢ per share, in its shipbuilding division to account for delays and higher costs on an amphibious assault ship named Makin Island, as well as estimated cost overruns and delays on other Gulf Coast ships caused by the diversion of resources to the Makin Island.

JPMorgan Chase (JPM) said in a research note that a $340 million charge would lower its 2008 earnings estimate for Northrop to about $5.00, from $5.65 per share. The consensus forecast is for $5.72 for the full year. (JPMorgan provided investment banking services to Northrop in the past year and expects to provide them within the next three months.)

Credit Suisse (CS) said in a research note that it doesn't expect a strong first quarter for Northrop and sees the company's results as more back-end weighted as aircraft programs ramp up through the year. (Credit Suisse does and seeks to do business with companies covered in its research reports.)

But Rubel at Jefferies says the slipup doesn't reflect Northrop's current business as much as problems that had started some time ago.

Defense Spending Up 8%

Defense spending, most of which goes to weapons procurement and research and development, climbed 8% in the first quarter, says Myles Walton, an analyst at Oppenheimer (OPY) in Boston.

The commercial side of the aerospace business also looks robust, with deliveries for large commercial aircraft rising 8% and orders up 110% from the first quarter of 2007, Walton says.

"Airline traffic growth did show some signs of deceleration and that has shown up in a couple of early earnings reports," says Walton. He cited a 3% decline in General Electric's (GE) large commercial aftermarket sales and flat sales at United Technologies' (UTX) Pratt & Whitney unit, both of which make aircraft engines.

Analysts concede that U.S. air traffic has slowed as airlines have cut capacity, but they say growth in global demand has compensated for that.

Credit Suisse noted that, against expectations, orders for new aircraft continued to grow in the first quarter, up 52% at Boeing (BA) and more than tripling at Airbus (EAD.PA) from a year ago. The order mix has shifted back toward narrowbody planes such as the 737 from widebodies in the quarter, analyst Robert Spingarn said in a research note.

Concern About 787 Delays

Any concern in the commercial business has been concentrated around Boeing's announcement in early April about production delays in the new 787 aircraft, with first delivery now pushed out to the third quarter of 2009 from early 2009 and unit delivery for 2009 cut to 25 from 109. The delays stem from shortages in parts from suppliers and engineering issues, as Boeing redesigned the midwing section of the plane.

The timing isn't expected to hurt Boeing's results in the first quarter, but UBS Investment Research (UBS) lowered its earnings estimates for 2009 and 2010 because of it. Meanwhile, the company's backlog is improving, increasing from 3,200 orders at the end of 2007 to 3,600 at the end of March, 25% of which are 787s, says Lahr at Stifel. Much of the backlog reflects international demand for new aircraft.

Peter Arment, an analyst at American Technology Research in Providence, R.I., warns that despite strong volumes, commercial aerospace results for the first quarter could be mixed, based on individual companies' exposure to certain platforms, such as the 787.

Spirit AeroSystems Holdings (SPR), which makes the front-section fuselage for 787s, has the most sensitivity to the 787 delays. But Spirit and other parts manufacturers with exposure to the 787 "are able to offset this delay by capturing other work out there," says Lahr at Stifel. Spirit is still winning a lot of business from the Gulfstream division of General Dynamics (GD), the Cessna unit of Textron (TXT), and United Technologies' Sikorsky unit, he adds.

Although domestic airlines have been able to offset a slowdown in U.S. air traffic with an increase in international travel, spare parts manufacturers such as Goodrich (GR) that are paid based on real-time traffic could see some weakness in earnings, Credit Suisse's Spingarn said in his note.

Lahr doesn't think there will be much of an impact on the parts manufacturers, since growth in U.S. air traffic has only slowed down from 5% to 2%.

No Negative Earnings Revisions

Deceleration in the U.S. air traffic was anticipated and is already priced into stocks, says Oppenheimer's Walton. Nearly all of the commercial aerospace names have had pullbacks in their stock prices from the highs of last November and December, exacerbated by oil prices above $100 and fears of a global recession, he adds.

While those factors have caused commercial aerospace price-earnings multiples to contract, they haven't prompted negative earnings revisions, he says.

Despite the delays, Lahr says he has no doubt that the 787s will fly. "We haven't seen one order canceled yet. And with oil at $110 per barrel, companies really want to capture the fuel efficiency of this," he says. "They can save 20% to 30% of their fuel costs."

Airlines also stand to save an additional 20% to 30% on maintenance costs, since the composite materials that go into 787s hold up better, the engines use more advanced technology, and flight checks required by the Federal Aviation Administration won't be as frequent, he says.

The upcoming election may cause investors in the aerospace industry to focus more on news headlines but otherwise won't have a meaningful impact on their confidence in the sector, says Lahr. "They may be thinking defense spending could slow if the Democrats take office, but historically defense spending has been tied to threats," he says. "This is a high-threat environment, so I wouldn't expect defense spending to slow down, and Democrats are the last people who can afford to stop spending on defense."

What's more likely if a Democrat wins the White House is that military spending would get redirected toward proven technology that could be used for the war at hand rather than on technology that wouldn't be used until 10 years from now, he predicts.

Investors, another group that tends to take the short view, will be anxiously watching as industry players report results in the weeks ahead.

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