From the November 2010 issue of Research Magazine • Subscribe!

November 1, 2010

Aerospace & Defense: Growth Seekers

By aligning their portfolios with the priorities of the Defense Department, aerospace firms should be able to navigate the changing government-spending environment.

Troy J. Lahr
Stifel Nicolaus
(443) 224-1319
tjlahr@stifel.com

Northrop Grumman (NOC) reported Q2:2010 EPS of $2.34 compared to our estimate of $2.26 and consensus of $2.19. The stronger results were driven primarily by segment margins of 8.7 percent, which beat our estimate by 50 basis points with stronger performance across all five segments.

Total sales increased 3 percent year-over-year, which was in line with our estimate as stronger growth from Technical Services and Shipbuilding were able to offset softness at Information Systems and Electronic Systems.

We are increasing our 2010 outlook by $0.01 to $6.85.

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Joseph B. Nadol III
J.P.Morgan
(212) 622-6548
joseph.b.nadol@jpmorgan.com

We believe Northrop (NOC) should deliver in line to above-average growth in the more challenging budget environment we foresee over the next several years.

NOC has the least supplemental exposure of the defense primes, insulating it from the declining Iraq budgets that we expect to be the main driver of lower spending. In addition, Northrop’s spots on manned and unmanned aircraft programs offer exposure to a portion of the budget that should hold up relatively well.

Performance concerns — particularly at the Gulf Coast shipyards — remain an issue; however, we view the company’s strategic realignment in Shipbuilding positively. Given the Shipbuilding industry’s substantial overcapacity, Northrop should be more cost competitive in the future, particularly as the company’s portfolio without the Ships business looks well-aligned with the Department of Defense’s long-term priorities.

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
hrubel@jefferies.com

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.

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