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June 01, 2008 at 04:00 AM
Several factors are driving demand in the aerospace market and make the sector highly attractive at this time, equity analysts say.
—
Patrick J. McCarthy, CFAFriedman, Billings, Ramsey & Co., [email protected]
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.
