The State of the Defense Industry: Earnings Reviews and Previews

One of the most pressing issues facing the United States centers on defense spending amid a global meltdown and a national deficit that has literally become out of control. With capital injections coming on an almost daily basis, can America continue to spend on defense? Will the new political party thwart all hope of military expansion? Fourth quarter earnings are coming in now, so it’s time to find out how we fared.

The top-tier defense companies are all tied into different markets. As such, the risks are different across the board and we have far-ranging estimates to the upside and downside on these companies… depending on where they are. I want to highlight the recent earnings from United Technologies and Lockheed Martin, and then get into a forecast of General Dynamics, Raytheon and Northrop Grumman.

United Technologies (UTX)

United Technologies released earnings Wednesday, January 21st, that were positive in general, but were really a mixed basket in terms of the company’s outlook on 2009. United reported earnings of $1.23 a share (an 8% increase) compared with $1.08 in the year earlier period. The firm had forecasted $0.98 cents, and beat this handily. However, since CEO Louis Chenevert and UTX typically issue conservative guidance, the call only slightly outpaced an earnings whisper of $1.22 per share.

United Tech has a very consumer-based portfolio versus other more “pure-play” defense companies, and saw these units lag heavily in the quarter. While their aerospace units did indeed help to counter-balance downward results from their Otis elevator and Carrier HVAC businesses, deferrals from emerging-market clients will continue to hold down 2009 guidance.

CFO Greg Hayes informed analysts that the conglomerate has seen notable deferrals impacting business in Russia and China. However, their jet engine business (Pratt & Whitney) and helicopter business (Sikorsky) both topped the expectation mark. Companies like United Technologies are feeling the heat from a stronger dollar (very unfavorable), so only a modest recovery has been forecast here.

Lockheed Martin (LMT)

During the fourth quarter, Lockheed Martin earned $2.05 per share, smashing consensus of $1.91 and an upside whisper of $1.93. Unfortunately, their earnings call on Thursday, January 22nd also yielded another cut in 2009 guidance. While guidance was originally forecast to be from $7.65-$7.90 per share, Lockheed brought it down to $7.05-$7.25; so much for the analyst expectations of around $7.85!

All things considered, it WAS a good quarter from Lockheed Martin… and they continue to be a best-of-breed producer with one of the best operating returns and track record we have available in a recessionary environment. Pension expense is always an underlying issue, but LMT seems to have done a better job than the Street anticipated.

Aerospace exposure could bite Lockheed Martin in the back if they don’t hit the ground running with their new F-35 fighter jet program. Additionally, it will be interesting to see how they develop their “cyber security” uniwhich curret, ntly has an excessive amount of unquantifiable information about it. This is a quality company, but be weary of their aerospace spin going forward.

General Dynamics (GD)

“The General” is set to report earnings on Wednesday, January 28th, and I anticipate an upside beat to the estimates at $1.58 per share. This could be a very interesting earnings play, as I believe that investors are underestimating the earnings contribution coming from GD’s Gulfstream business jet segment, which has been filling orders just as fast as it can take them according to recent research from Merrill Lynch. Because of this, I can easily see General Dynamics, behind CEO Nick Chabraja, bucking the defensive trend.

A warning note comes with the upside whisper I am offering, and that is toward this same Gulfstream jet unit. After the three Detroit CEOs flew into Washington on private jets to ask for a bailout for Auto Nation, it is becoming more and more frowned upon to have a corporate jet for transportation. The bottom line is, I feel that in 2009 and 2010 the trend will be that “coach is cool.”

Elsewhere in the business, the defense portion of the portfolio behind GD’s tanks and mine-resistant vehicles is still performing well with the United States’ war in Iraq. Additionally, the Information Systems & Technology unit (which controls a dominate EBIT position at 54% of the total) has been winning contracts with the U.S. Military for maintenance and repair on a consistent basis.

Unlike other defense companies, General Dynamics will not have an EPS impact from pension plans because of an odd exception to regulation that allows them to mark off pension expense on the balance sheet… away from net income. Bottom line: the General might call for a nice earnings play, but I would suggest RTN or NOC for the year.

Raytheon (RTN)

I feel that Raytheon will report earnings in-line (a few cents to the upside) with their peers in the defense industry. The Street is currently estimating earnings at $1.10, though I feel they will marginally outperform (I estimate $1.13) because their improvements on working capital and on-going success.

The problem with Raytheon, in my mind, is that expectations are simply too high. They were the best performing large-cap company in the aerospace and defense field in 2008, and really command a strong portfolio that will be tougher for Obama to shake up with defense budget cuts relative to their peers. That being said, companies that outperform consistently will eventually get ahead of themselves… and while growth will be solid in 2009, the better play in my opinion is Northrop-Grumman.

Like the other defense names (minus GD), RTN will be facing additional EPS pressure from headwind from their pension expenses. However, Raytheon has significant drivers going forward with the United States’ plan to develop a missile defense network in Europe to guard against terrorist attack. This project has already come under fire by enemies seeing this as an offensive move, but should get steady revenues in 2009 to Raytheon’s hyper-diversified portfolio with ~20% of revenue coming from missile systems.

Raytheon and Lockheed Martin are the two most active names (in my opinion) on the “cyber space” front. In the past 18 months, Raytheon acquired 3 network-security providers. As the world evolves into a globalized network of computers, these two could lead the charge in cyber-technology.

Northrop Grumman (NOC)

Over the past four quarters, Northrop Grumman has missed earnings expectations 3 out of 4 times. Additionally, pension expense is a variable that is least-visible in this company versus its peers and could make-or-break the earnings call. With this in mind, why in the world would I be recommending the stock? Expectations.

As the worst performing “big defense” company in 2008, Northrop really only needs to perform as “average”, not even above average, to outperform. We’ve seen this take effect already, as they are the best-performing stock in the Bullish Bankers defense coverage universe for 2009. Their portfolio is literally built for a Barack Obama presidency, with its revenues split up well between industries largely based on reconnaissance and surveillance, areas that will continue to see receive funding despite other potential cuts in 2010.

Other than their defensive portfolio, Northrop has many new technologies in development, such as their missile warning system, the “NexGen MWS.” This next-generation system will largely improve the U.S. Air Force’s ability to defend our planes from rebel shoulder-fired missiles. Essentially, this one could be a game changer for anything heat-seeking in nature.

Shares of NOC traded UP on Thursday, January 22nd, after management announced they would be writing down anywhere from $3 to $3.4 billion on goodwill. This comes on the back of investments in Litton Industries Inc. and TRW Inc. made in 2000 and 2001. However, this should be merely a “paper loss” that will not materially impact earnings going forward.

Conclusion

When we look across the defense industry, I feel that the earnings will continue to beat estimates as United Technologies and Lockheed Martin have. Please check out my previous article entitled “Ready, Aim, FIRE! Defense Sector is Loaded” for more information into the defense sector beyond earnings and into 2009. I am under the full impression that in this recessionary environment, defense names hold a unique value to investors because of their strong balance sheets and defensive (literally) portfolios.

We seem to be entering into a global arms race, with tensions on the rise between nations. Additionally, it is important to remember that, historically, as the global economy declines, so do international relationships, typically devolving into conflicts. This will be something to keep in mind going into 2009 and beyond. Stick with the defense names for big gains during earnings season!

-Jim Regan

Disclaimer: The mutual fund that the author works with is long GD

Comments

[brutallyfrank:]

Are you smoking crack or what?

All of these companies are worth a little more than half of what they were a year ago.

The U.S. got into this financial mess partly by over-spending in defense, intelligence, and IT.

Consider these areas as national "insurance", and ask yourself how much fcuking insurance can we afford?

These areas are definitely NOT stimulative, and in fact, suck tax dollars from the lower and middle incomes and push them up the wealth ladder -- to the more "educated" dolts in our country (engineers, scientists, etc).

What the country needs is to push wealth down the economic ladder to all the "joe the plumbers".

Maybe you need to be in another line of work.

Mar 01 08:29 PM