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What Happened To Defense Industry?

Aug. 02, 2013 9:53 AM ETGD, LLL-OLD, LMT, NOC
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A handful of defense contractors beat earnings readily last quarter. Companies also raised their 2013 outlooks. It seems as if the sequestration effect does not exist. In short, strong operating performance is a big contributor to earnings. Looking forward, cost control is the key to remain current EPS level in the next few quarters.

With that said, there are weaker players that have less to trim and further cut would hurt productivity. We sample General Dynamics (GD), Lockheed Martin (LMT), L-3 communications (LLL), and Northrop Grumman (NOC).

GD: Q2 2013 operating earnings of $1.81 per share. Earnings were up from the year-ago figure by 4 cents. Operating margins in Q2 2013 were 11.8%, unchanged with prior-year level.

Segment

Revenue

Change prior-year

Operating income

Change prior-year

Aerospace

$2,052M

29%

$389M

51.4%

Combat Systems

$1,549M

(27.9%)

$218M

(32.3%)

Marine Systems

$17,759M

6.4%

$178M

(2.7%)

Information Systems

$2,550M

0.9%

$198M

(12.3%)

LMT: Q2 2013 EPS $2.64 per share due to strong operational performance, up 11% from year-ago. LMT did forecast a revenue reduction of $825M due to military spending cut in 2013. Revenues fell 4%.

Segment

Sales

Change prior-year

Operating profit

Change prior-year

Aeronautics

$3,407M

Unchanged

$407M

($47M)

Information Systems

$2,101M

($162M)

$19M

$14M

Missiles and Fire Control

$2,043M

$200M

$381M

$68M

Mission Systems & Training

$1,770M

($249M)

$275M

$80M

Space Systems

$2,087M

($301M)

$276M

($24M)

LLL: Q2 diluted EPS $2.03, an increase of 5% year-over-year. Net sales were up 2%. Operating margins, however, have seen minor decrease.

Segment

Sales

Change prior-year

Operating margin

Change prior-year

C3ISR

$881.7M

$19.7M

7.8%

(2.2%)

Electronic Systems

$1,357.4M

$5.1M

11.2%

(1.4%)

Platform and Logistics Solutions

$620.3M

$28.8M

10.6%

1.9%

National Security Solutions

$332.8M

($4.4M)

5.9%

(0.8%)

NOC reported Q2 EPS $1.97 per share due to stock repurchase and strong operating income, up 4.1% year-over-year. Operating margin rose to 12.8% from 12.3% a year before. Sales were flat.

Segment

Sales

Change prior-year

Operating income

Change prior-year

Aerospace Systems

$2.61B

8.7%

$336M

15%

Electronic Systems

$1.8B

1.5%

$322

17%

Information Systems

$1.7B

(9%)

$141M

(30%)

Technical Services

$722M

(7.8%)

$69M

(7%)

We compare quarterly EPS to identify trends. NOC and LLL have seen downward trend, even with stock buy-back program. LMT currently has the highest quarterly EPS in the past four years so it is reasonable to think it would be harder to boost EPS anymore. We rule out GD's quarterly EPS because it gained strongly in Q2 but is a bit harder to judge as it had abnormal Q1 earnings. So we think GD's EPS Q2 was an outlier. If we were to ignore GD's Q1 2013, GD would have been flat as well.

When coming to gross profit, only LLL has downward trend while the other three are uptick. Note that LLL has the smallest profit base among the four. This also means L-3 has less costs to cut while sailing through the sequestration. Up to this point, we may suggest LLL be the least well positioned. So look further on quarterly revenue to seek confirmation.

LLL indeed is the only one showing downward trend in quarterly revenue. Sooner or later L-3 needs to come up with more operating performance to offset revenue shortage when the sequestration headwind comes at full throttle.

Conclusion: LLL is the weakest one among the four. If sequestration indeed starts hits the industry, which few would doubt it won't, LLL may be the hardest hit. In order to keep up with the peers, both LLL and NOC need to cut more costs or buy back stocks to keep with its peers while not hurting its productivity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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