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Wednesday, August 25, 2010

Be Wary of the Defense Stocks

This is not the time to be loading up on defense stocks. The department of defense's fiscal year 2012 budget request will be submitted in February and the discussions leading up to it will pressure the defense stocks. Also, given a shrinking backlog for many of the companies within the sector, I believe that consensus estimates remain meaningfully too high and will be revised downward throughout the 2nd half of 2010, particularly if current pension assumptions (i.e., interest rates and asset returns) hold.



Northrop Grumman Corp. (NOC) on July 28th, Northrop reported adjusted 2nd quarter EPS ahead of consensus, and revised guidance higher --- highlighting improved margin performance. However, cash flow was weak and Northrop joined the list of defense companies to report declining backlog and weak bookings. Here are my concerns regarding Northrop and why it is a stock to sell: 1) the company is way too leveraged to the defense sector view where I expect pressure on Department of Defense spending and contractor margins. Northrop also joined the list of defense companies reporting weak book-to-bill on the back of another sequential decline in backlog. 2) While Northrop showed some margin improvement in the 2nd quarter --- outside of ships --- its margins and returns on capital remain the lowest in its peer group. 3) If interest rates and asset returns simply stay where they are today, 2011 and 2012 estimates could be reduced down by 11% (of current EPS) or even more.

During the earnings conference call, management commented on downside risk at the Information Systems division given order delays that could be exacerbated in 2011. There is also uncertainty in Aerospace Systems guidance given the restructuring of NPOESS* and the ongoing review of Global Hawk. Northrop is currently reviewing the implications of a fixed price contract on aspects of the F35's development which may have implications for Northrop's' Aerospace, Electronic, and Information Systems group. On July 13th, Northrop announced that it may incur "substantial restructuring and facilities shutdown-related costs including, but not limited to, severance, relocation expense, and asset write-downs" at its Shipbuilding division.



Lockheed Martin Corp. (LMT): In the most recent quarterly earnings release, we learned that Lockheed's backlog declined again, which has occurred in five of the past six quarters. Costs related to the voluntary attrition program and potentially large incremental pension headwinds loom in the 2nd half of 2010. I am also concerned with trends in Lockheed's large Government IT/Services segment, and I see significant remaining risk on the F-35 development. The good news is that Lockheed ended the quarter with $2.7 billion of cash ($7.32/share) on its balance sheet, and net-debt/cap of 26% (46% when adjusting for underfunded pension).

However, notable uses of cash in the quarter include $350 million in pension payments and $782 million in share repurchases (9.7 million shares). Management anticipates an additional $400 million of pension contributions in the 2nd half of this year, but has highlighted the possibility of making additional contributions depending on the direction of discount rates and asset returns.



Iridium Communications Inc. (IRDM): Now here's a company that is in a growing area of defense and intelligence agencies contracting, but that is facing a near-term headwind. Headquartered in McLean,VA. Iridium's mobile voice and data communications solutions are supported by the only truly global communications network with coverage of the entire Earth --- including oceans, airways and Polar Regions. I have always been a believer that this sector - satellite phone and data services - could eventually replace cell-based phones.



Also, these satellite phones and data services are integrally important and used by all branches of our military. For this reason, revenues should only rise for the companies in this sector. The problem for Iridium is that they are replacing their current satellite system with "Iridium NEXT", a next-generation satellite constellation. The timing couldn't be worse. In their own words, from their most recent 10-Q, Iridium explains, "The recent global economic crisis and related tightening of credit markets has also made it more difficult and expensive to raise capital". Of course, Iridium also has to deal with competitors such as Inmarsat and Globalstar.



Iridium estimates that, "the aggregate costs associated with the design, build and launch of Iridium NEXT and related infrastructure upgrades through early 2017 to be approximately $3 billion." Iridium expects "to fund $1.8 billion of these costs from a COFACE-backed debt facility or other debt or equity financing, with the remainder to be funded from internally generated cash flows, including potential revenues from secondary payloads and warrant proceeds." Another issue is the additional $1.2 billion needed to make up the entire $3.0 billion cost. The company comments in their 10-Q that they are planning on using some warrants to raise some of that cash. However, the 10-Q also states that "a portion of the warrants whose proceeds we expect to use to fund a portion of Iridium NEXT are currently "under water," meaning they have an exercise price per share that, for certain of our warrants, is significantly higher than the current price at which our common stock is trading. In addition, none of the warrants are callable by us until such time as our stock trades for an extended period of time at a per share price greater than $14.25 for our $7.00 warrants, or $18.00 for our $11.50 warrants". Until the financing is behind Iridium, I am wary of this long-term player in this growing sector.


Be Wary of the Defense Stocks originally appeared on BloggingStocks on Tue, 24 Aug 2010 17:32:00 EST. Please see our terms for use of feeds.

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Northrop Grumman - Lockheed Martin - Satellite phone - Business - United States Department of Defense

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