From the December 2011 issue of Research Magazine • Subscribe!

Moving Higher

Reasonable valuations and solid performance continue to draw investors.

Troy Lahr
Stifel Nicolaus
443-224-1319
tjlahr@stifel.com
Commercial aerospace: Demand for new aircraft at Boeing and Airbus remains robust with combined orders through September of approximately 1,700. Airbus’ introduction of the A320-NEO is largely responsible for the surge in orders with over 1,000 orders for the aircraft. In addition, we have begun to see increased interest from domestic airlines looking to recapitalize their aging fleets following years of underspending.

Defense industry: Over the past few weeks, we have noticed a renewed investor interest in many defense companies. Many investors seem to be drawn toward relatively low valuations (7-8 times earnings for many large-cap defense companies), attractive dividend yields (3-5 percent) and meaningful share repurchases.

Announced daily Department of Defense (DoD) contracts were significantly higher during the third quarter compared to awards last quarter. Total awards announced for the five major defense companies totaled $20.3 billion compared to $11.9 billion during 2Q11 and $14.1 billion during 1Q11. Boeing had announced DoD awards of $3.4 billion ($3.0 billion last quarter) while Lockheed Martin had slightly lower awards quarter over quarter ($3.5 billion versus $3.9 billion). Raytheon’s announced awards increased 50 percent to $3.0 billion due to numerous awards for missile systems.

Northrop Grumman (NOC) also had a healthy increase in orders compared to last quarter, but General Dynamics had the largest increase to $8.5 billion in announced awards compared to $1.5 billion last quarter. The strong order flow at GD was attributable to awards to the Zumwalt destroyers and a sizeable IDIQ contract at C4 Systems.

Northrop Grumman: [The] company reported Q3 2011 EPS of $1.86 compared to our estimate of $1.75 and consensus of $1.68. Results benefited by ~$0.08 from a lower tax rate, which helped to offset a $0.04 headwind from higher below-the-segment line expenses.

Outlook: We are increasing our 2011 EPS estimate by $0.15 due mainly to the results in the quarter and slightly better segment margins. We are reducing our 2012 EPS estimate by $0.05 to $7.15 as a lower sharecount is being offset by lower sales growth.

Howard A. Rubel
Jefferies
212-284-2126
hrubel@jefferies.com
Northrop Grumman (NOC) reported Q3 2011 EPS of $1.86 vs. our estimate of $1.62. The differential was due to better operating profits in Aerospace and Electronics ($0.14), lower general corporate expenses ($0.06), a lower tax rate ($0.05), and a reduced sharecount ($0.02), offset by $0.03 of higher intersegment eliminations. NOC continues to take aggressive measures to rationalize its portfolio for a challenging budget environment and reduced op[erational] tempo.

We are raising our 2011 EPS by $0.15 to $7.10 and lowering our 2012 EPS by $0.05 to $7.45. Portfolio trimming pressures revenues, but also creates a leaner and more focused business. NOC should continue to generate annual free cash flow above $1 billion before pension contributions. We decreased 2012 revenues by about $1 billion to $26.7 billion, but a lower sharecount offset most of the revenue reduction. A flat to slightly down defense business, which can continue to generate strong cash flow to reduce sharecount, is the sector’s new growth company.

Management continues to focus the company in four areas: Cyber, C4ISR, Unmanned and Logistics. Management has identified these areas where the company can offer a differentiated product or service.

Each of these areas of the budget is expected to be mostly insulated from deep cuts. None of NOC’s major programs is believed to be a significant cause for concern. Information Systems is likely the most vulnerable. We have revenues in the segment trending down to about $7.7 billion in 2012 from $8.1 billion in 2011. Information Systems (IS) is one area receiving particular emphasis for portfolio shaping. The sale of the County of San Diego outsourcing contract, about a $400-million annual business, is one example. It is also impacted by the Continuing Resolution and reduced funded from budget disruptions.

Joseph B. Nadol III
J.P. Morgan
212-622-6548
joseph.b.nadol@jpmorgan.com
NOC delivered another strong quarter driven by better than expected margins, and management raised guidance for the year ... Management’s 2012 pension guidance was much better than we anticipated, and we are increasing our 2012 and 2013 GAAP EPS estimates accordingly (although it is important to note that changes in pension estimates have no impact on our price target or rating as we derive both from pension-adjusted numbers).

We are increasing our 2011 EPS estimate by 20 cents from $6.85 to $7.05 due to 30 basis points of margin improvement and a lower than expected sharecount. We are also increasing our 2012 and 2013 EPS estimates by $1.00 and $1.05 to $6.60 and $6.40, respectively, due largely to our much improved pension outlook. A lower sharecount also helps, while our underlying operating outlook remains essentially intact. n

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