Defense Sector Investors Should Carefully Monitor Earnings, Guidance

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Includes: BA, GD, LMT, NOC
by: J Clinton Hill

[Updates below]

While scanning Monday morning’s news, defense spending is a theme that stood out and led me to check the price action of several stocks. Here is what I gleaned from my quick analysis. (Readers who have more in-depth knowledge of the defense industry are welcome and encouraged to share their comments and constructive feedback for the benefit of us all.)

Defense budget
President Obama’s fiscal year 2010 budget for the Pentagon is about $533.7bn, but the devil is in the details which Defense Secretary Gates is expected to release later today, i.e. Monday. The GAO (Government Accountability Office) issued a report that 96 of the Pentagon’s biggest projects were $296bn over budget. Some of the budget overrun is blamed on the Pentagon low-balling contracts from the start and committing to purchasing unproven technologies and then later modifying these same programs as they evolve. It is not surprising to see many analysts predicting the Pentagon’s larger programs as the most vulnerable to budget cuts during the nation’s financial crisis. Military analysts also think that Gates may propose cuts to programs such as the Navy destroyer, missile defense shield, Army modernization, and reduction in F-22 fighter jets. Stocks that could be impacted are General Dynamics (NYSE:GD), Lockheed Martin (NYSE:LMT), Boeing (NYSE:BA) and Northrup Gruman (NYSE:NOC).

This group merits attention on investors’ radar screens, especially as we approach earnings season. One should monitor defense spending cuts and their impact on earnings models going forward. The table below indicates that some analysts have already made downward revisions over the last four weeks. During the market’s rally, the group slightly underperformed the S&P 500 over a 4 week period and for the last week underperformed the benchmark index by -5.22% on average. This relative weakness should not be taken lightly.

Technically, LMT has already broken its short-term uptrend and trades below its moving volume weighted average price, thus suggesting that institutions may be only willing to pay lower prices for the stock. BA, NOC, and GD remain in a short-term uptrend but are clinging to support at their moving volume weighted average prices which are losing momentum and displaying negative divergences.

Investors who may be long shares of these stocks might considering hedging with covered calls or option collars. Aggressive investors may want to keep these names on their list of short-candidates in the event the recent market rally undergoes a correction since these names have displayed relative weakness. Regarding earnings, any significant downward revisions or negative guidance are also likely to impact these stocks.

>>>Update #1>>> Well so much for today’s theory on relative underperformance… Defense Secretary Gates has released details on defense spending and while some programs may be cut, the trade-off will be increased spending in other areas controlled by the major defense contractors. This was a bad call and I have to acknowledge it. In hindsight, the error lies with the assumption that news would be bad because many anticipated such, instead of waiting for the actual news release and allowing flexibility that news could go in either direction, i.e. bullish or bearish. Still, it will be interesting to see how these companies report earnings and more importantly, guidance going forward.

>>>Update #2>>> Upon re-reading a summary of the details for re-aligning the Pentagon’s spending priorities, the basic math still looks like a net loss of business for some of these contractors. I could be wrong, but I think the market’s reaction to this news was excessively bullish and it would be more prudent to wait for this quarter’s earnings and guidance and listen to their conference calls. For details on Defense Secretary Gates’ Pentagon spending policies, please see the Wall Street Journal report. For a more in-depth analysis on his vision for overhauling the Pentagon, please see his essay in Foreign Affairs: A Balanced Strategy: Reprogaming the Pentagon for a New Age.

Disclosure: Hillbent.com, Inc. or its affiliates may own positions in the equities mentioned in our reports. We do not receive any compensation from any of the companies covered in our reports.

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