Aerospace & Defense: Growth Seekers

NOC faced a formidable pension headwind in 2009, because it does not smooth the impact of plan returns on pension expense; but the fact that NOC took the hit up front means the company does not face the continued headwinds from poor 2008 results that some of its peers do.

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Howard A. Rubel
Jefferies & Company, Inc.
(212) 284-2126
[email protected]

Northrop Grumman (NOC, Buy rating) reported Q2:2010 earnings per share (EPS) of $2.34 versus $1.13 in the year-ago period. Adjusted for the tax benefit and the charge at shipbuilding, core EPS was $1.61 versus our estimate of $1.47. The strong results in Aerospace and the IT Services adjustment were the major differences.

Among the reasons we rate NOC a Buy is its strong and broad position in the intelligence, surveillance and reconnaissance (ISR) market. The U.S. military has concluded that persistent awareness, cyber warfare, and enhanced sensors provide improved tracking and targeting, as well as better protection for soldiers. There are likely to be increased resources devoted to this market relative to other portions of the budget.

We believe aerospace stocks are likely to benefit from the ongoing recovery in global traffic and yields.

The requirements for the war in Afghanistan coupled with efforts to restrain the U.S. Government's spending have begun to stress the long-term budget for the Department of Defense (DoD), [though,] which is in turn putting pressure on revenues and margins of defense contractors.

Under Secretary of Defense Ashton Carter, [there's been] further guidance on the DoD's efficiency initiative to achieve $100 billion in savings over five years. He outlined 23 changes to the way the DoD contracts for goods and services divided among five categories: affordability, productivity, competition, service acquisition, and non-productive processes. The DoD has its sights squarely set on service acquisitions. We believe challenging times are ahead for many who supply services to the DoD.

The Defense Subcommittee of the U.S. Senate Appropriations Committee provided $670 billion for fiscal year 2011, $8.1 billion below the request. Most notably, it reduces funding for the Littoral Combat Ship program by one, deletes 10 aircraft from the F-35 program, and eliminates the alternate engine for the F-35. However, Army and Marine Corps attack and transport helicopters, Stryker vehicles, and the Marine Corps cargo UAS programs all benefit from increased funding.