From the June 2008 issue of Research Magazine • Subscribe!

'Tremendous Opportunity'

Several factors are driving demand in the aerospace market and make the sector highly attractive at this time, equity analysts say.

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Patrick J. McCarthy, CFAFriedman, Billings, Ramsey & Co., Inc.703-469-1236pmccarthy@fbr.com

Sector Outlook: The fundamental drivers of defense are different than those of the rest of the market, and they remain solid, in our view. As a result, we think the recent sell-off represents a tremendous opportunity to invest in the space.

The underlying fundamentals of the defense industry are driven primarily by two things, in our opinion: the current global-threat environment and defense spending. Therefore, we view many of the broader market concerns, including the potential for a recession, housing price declines, and subprime issues as relatively inconsequential to the group's performance.

Additionally, we do not see the global-threat environment substantially improving, we believe that growth in defense budgets will continue to rise (albeit more slowly than in the recent past), and we think (in general) that consensus expectations for 2008 are too low.

Those factors, combined with the massive drop in the market's expectations for operating-income growth, make the defense space as attractive as we have seen from a valuation perspective over the past several years.

With expectations this low across this many companies, you can be hyper-selective, in our opinion, and we still favor those companies with great visibility, stable operating margins, and great free cash flow. When we factor in expectations, Lockheed Martin (LMT), Raytheon (RTN), Alliant Techsystems (ATK) and DRS Technologies (DRS) jump to the forefront as the best buys in the group today, but they are certainly not the only ones. We are also upgrading ATK, L-3 Communications Holdings (LLL) and Northrop Grumman (NOC) from Market Perform to Outperform.

Why Northrop Grumman (NOC)? Northrop Grumman reported earnings that were in line with consensus expectations. For 4Q07, the company reported $1.32 EPS from continuing operations, just below our $1.33 EPS forecast and slightly higher than a consensus $1.31 EPS estimate. Revenues in the quarter were $8,824 million, which was bolstered by the ships and aerospace businesses, primarily. Top line was $381 million ahead of a consensus estimate of $8,443 million. Looking to 2008, NOC indicated that revenues would grow about 3 percent to $33 billion, driving 7.5 percent to 12 percent EPS growth. Based on the results in the quarter, we are maintaining our Outperform rating and $84 price target.

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Joseph B. Nadol IIIJP Morgan212-622-6548joseph.nadol@jpmorgan.com

Sector Outlook: The Air Force selected Northrop Grumman/EADS over Boeing to build 179 aerial refueling tankers in a surprise decision. The near-term earnings impact for NOC should be relatively small but should become more substantial as the program ramps. For Boeing, this was a significant strategic loss.

About Northrop Grumman: We are maintaining our NOC estimates for now, but $832 million of development funding in the FY09 budget may add about 5 cents in '09 depending on how quickly the money is spent. NOC has said its forecast for nearly 8 percent annual aeronautics growth includes only a factored number for the tanker, indicating this business could grow even faster.

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Paul NisbetJSA Research, Inc.401-847-1103PaulNisbet@jsaresearch.com

About Northrop Grumman: The NOC stock is currently selling at 15.2 times our forward 4Q EPS estimate, versus the 17.1 times average of the other defense-oriented large cap companies we follow -- at an 11 percent discount. We believe that the market has been allotting NOC a low valuation because of concern regarding it shipbuilding business, with all the stories regarding the Navy's budget squeeze, cost overruns and the impact of Hurricane Katrina, most of which is now history. Northrop Grumman's shipbuilding, however, now has a $14.1 billion backlog (over 2.5 years of sales at the estimated 2007 rate), $10.2 billion of which in funded -- which should allay some of the budget fears.

We are remaining with our price target multiple of 16 times and our price targets for the end of 2007 of $89, and for a year later of $97. The latter target represents an 18 percent average annualized total rate of return over the next 15.5 months. We thus continue to rate the NOC stock a Buy.

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