Major defense players soldier on with positive quarterly results

Third-quarter earnings calls indicate upward revisions to earnings estimates for 2009

Despite today’s discouraging headlines of growing deficits, budgetary pressures, and Defense Department program cuts and cancellations, the Big Five – Boeing Co., General Dynamics Corp., Lockheed Martin Corp., Northrop Grumman Corp. and Raytheon Co. – remain resilient in their performance and moderately optimistic about their future prospects.

These large prime contractors have recently completed their earnings announcements and investor calls, and on the minds of everyone in the industry is the implication of current defense policy on the growth, performance, and strategy of these key, bellwether players. With regards to financial performance, these large prime contractors have posted solid revenue and profit growth in 2009 and have cautiously deployed capital.

National security requirements and international sales opportunities are expected to continue to support growth into the future. Despite the modest but bullish outlook for growth, these large prime contractors acknowledge the significant challenges facing the industry, including the uncertainty of strategy in Afghanistan, continuing budget pressure, contract delays and cancellations and protest activity. These factors have lead to an operating philosophy squarely focused on risk management, portfolio rebalancing and business execution.

These large prime contractors have achieved overall solid revenue growth and stable operating profit from operations in 2009, with growth of 5.8 percent and 2.7 percent, respectively over 2008 levels. For the full year, aggregate revenue for the large prime contractors will exceed $200 billion. Services revenue for the group, totaling about 25 percent of aggregate revenue, is up 9 percent year-over-year, with operating margins slightly above 9 percent (well below total company operating margins at 200 to 300 basis points higher). Among the growth drivers, international sales, command and control, unmanned systems, simulation and training, logistics, and intelligence, surveillance and reconnaissance (ISR) lead the positive top-line trend.

During their third-quarter earnings calls, each of these large prime contractors, with the exception of Boeing, announced upward revisions to earnings estimates for 2009. Looking further ahead, the companies that commented on performance for 2010 and beyond, expect annual long-term growth of four to six percent, consistent with the single digit budget growth called for by Defense Secretary Robert Gates.

Balance sheets remain strong, with aggregate net debt of only about $11 billion, a fraction of senior debt capacity. Capital has been strategically managed with a sound mix of share repurchases, dividend payments, discretionary pension funding and acquisitions. Share repurchases topped $5.6 billion year-to-date through Sept. 30 for the five companies, slightly lower than year-to-date 2008 totals of about $6.0 billion. Share repurchases have been a key contributor to earnings per share growth.

These large prime contractors have cautiously deployed capital in 2009 to fund what could be called highly strategic acquisitions. While significant acquisition capacity exists (more than $50 billion), year-to-date transaction value totaled under $2 billion (9 deals) in the aggregate, about half the transaction value (13 deals) reported in the year-to-date 2008. Many of the 2009 deals reflect the acquisition of key technology in growth markets, including:

  • Raytheon's acquisition of BBN (network technology). 
  • Northrop Grumman's acquisition of KillerBee (small tactical unmanned aerial system platform).
  • General Dynamics' acquisition of Axsys Technologies (precision optics).
  • Lockheed Martin's acquisition of Gyrocam (ISR) 
  • Boeing's acquisition of eXMeritus (cyber security).

Transaction pricing for companies with proven technologies and compelling growth prospects remains strong -- at double digit earnings before interest, taxes, depreciation and amortization multiples. Notably, cash deployed for discretionary pension contributions have been more than double the amount of cash to fund acquisitions in 2009, and cash deployed to fund share repurchases has been than triple transaction value.

Year-over-year, stock prices are mixed for the group, with pricing based on performance, risk and market positioning. Looking ahead at the extraordinary pressure on defense budget leads one to wonder whether there might be a major paradigm shift in industry. What budget priorities can possibly replace the prospects of shrinking dollars for defense platforms?

While funding pressures clearly exist, enormous national security threats and the need to support the warfighter will continue to generate opportunities for technology advancements and growth, tied to the national security imperatives. Meanwhile, the prime contractors are adjusting their portfolios to align with the “80 percent solution, the multiservice solution that can be produced on time, on-budget and in significant numbers” as directed by Gates.

One thing is clear, if the industry is facing prospects of a decline, no one told the Big 5.

About the Author

Jean Stack ( is the director of the aerospace, defense and government group at the investment bank Houlihan Lokey.

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