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U.S. Defense Contractors - A Forgotten Growth Industry?

Posted on: July 21, 2008 - Email Article - Printable Version

Jim Regan

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As we head into the peak of the second quarter earnings season, the major U.S. defense contractors have yet to feel the full benefit of continued global security threats that promise expectation-topping results. With strength coming from ongoing conflicts in the Middle East, record-breaking backlogs and plenty of company-specific catalysts… cheap valuations have these companies well positioned to see immediate gains.

The Fears that Spooked the Bulls
There’s no denying that the aerospace & defense contractors have felt the blow of a shaky investing environment, even more-so with staggering prices of oil cutting into budgets. However, the demand for defense equipment has never been stronger. It is in my view that most of the fear thus far has developed from the ongoing U.S. presidential election. Historically, defense contractors have performed much better under Republican administrators. With polls favoring Democrat candidate Barrack Obama at this point in time, investors have been selling out core holdings in the defense sector that had previously been known as safe havens during economic periods of tension.

Even assuming that Barrack Obama wins election, are these reasonable suspicions over-hyped? There is surely going to be a lot more rhetoric surrounding the election in November, yet there are plenty of reasons why the defense budget will remain strong. Most notably, no candidate can escape the key focus of spending on homeland security. And truth be told, the election will ultimately have little effect on short-term defense politics.

The largest factor impacting the defense contractors over the next year could very well end up being the battle between the White House and Congress over the financial year 2009 defense budget. Any delay in the decision may hurt the effectiveness of future funding as well as supplemental spending bills. Yet to this date, there remains no real cause for concern.

An Uninformed Downtrend
Knowing that the defense budget remains stronger than the current valuations suggest, a 16.03% decline in the SPADE Defense Index year to date seems entirely out of line. A recession-proof industry by nature, the defense sector has fallen out of favor by the hand of a commodity boom and politics. Despite recent tension, the defense sector as a whole saw an EPS growth rate of 72.1% over the past year, and remains bullish with an expected 22.5% annual yield three to five years into the future.

Confirming this pattern of buying on weakness, United Technologies [UTX: 55.00, +0.70 (+1.29%)] was the first big name to release earnings, and managed to beat the Street’s EPS estimates of $1.30/share with $1.32/share on strong showings from their Otis elevator business and Carrier HVAC units. Yet more importantly, UTX was able to raise guidance into the future citing strong overseas market growth and global demand for aircraft. There are many similarities between United Tech.’s business and the other contractors; however, while UTX opened higher, the peer group failed to follow suit.

The Street Sleeps on Upside Earnings Guidance
A positive surprise in earnings from UTX could have easily set the pace for the group. But despite upward whispers from General Dynamics, Lockheed Martin, Raytheon and Northrop Grumman… we have yet to see any notable appreciation in prices.

General Dynamics: With increasing demand for its flagship Gulfstream commercial-aircraft unit, General Dynamics [GD: 60.73, +0.99 (+1.66%)] should surpass consensus estimates of $1.43 a share (whisper $1.48) with a rising backlog totaling almost $50 billion from hyped tank and armored truck demand in Iraq and Afghanistan. They release before the bell Wednesday, July 23rd.

Lockheed Martin: As impressed as I was with the new F-22 Raptor, a plane judged too advanced to sell even to allied nations, a major beat from a consensus $1.88 is expected from a big contract win over Boeing to supply next-generation navigational satellites to the U.S. Air Force. A strong whisper of $1.95 could be an understatement to Lockheed Martin’s [LMT: 83.995, +0.145 (+0.17%)] dominant stance on foreign revenue increases into the future. They release earnings before the bell Tuesday, July 22nd.

Raytheon: Despite cautious forward guidance from the first quarter earnings release, when Raytheon [RTN: 52.035, -0.455 (-0.87%)] announced record backlogs on strong double-digit growth, a three cent upside whisper from the Street’s $0.92/share bet could very well suggest that concerns were over-hyped. A company that according to JP Morgan, should trade at premium levels, RTN shouldn’t have much trouble outperforming on several international contracts when they release earnings Thursday, July 24th.

Northrop Grumman: Northrop Grumman [NOC: 48.58, -0.72 (-1.46%)] was recently put into the spotlight as a $40 billion tanker contract awarded to them over rival Boeing [BA: 46.05, -0.12 (-0.26%)] was put back up for discussion. It is my understanding that Northrop Grumman is still the front runner in this second look, and stellar growth from Northrop’s various shipyards justify a four cent upside whisper from the Street’s consensus $1.41 a share. They release earnings next Tuesday, July 29th.

The biggest highlight in the defense sector that demonstrates strong trends is favorable M&A activity under a U.S. Defense Department that caters to these companies, funding small organizations to foster growth. There has been a staggering concern put toward foreign companies using a favorable Euro-Dollar exchange to potentially buy out U.S. defense contractors, despite clashes with the U.S. Congress. I believe that this fear is largely overdone, and rather is a testament to the strength in overseas end markets that have steadily hiked demand for U.S. manufacturing services.

Knowing that all five major U.S. contractors have shown strong upside potential on strong demand and record-breaking backlogs, it’s hard to justify discounted valuations at current levels when things seem to be holding up quite a lot better than the overall markets. A rebound seems all but evident, as the SPADE Defense Index typically shows its strongest growth in August and September, last year up 3.14% and 6.35% respectively.

Earnings season could be especially beneficial to a defense industry that is down on its luck. Watch out for a surprise beat from Lockheed Martin, which could open up renewed confidence in the sector and fantastic buying opportunity for the later calls. Perhaps the sector has simply be reacting to an overall market slow down, but the growth is real, demand is strong, and the hit these reliable blue-chips have taken over the past year may be unjustified by their bookings.

-Jim Regan

Disclaimer: The author holds a long position in GD as a manager of the Nittany Lion Fund, LLC

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