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Employee Dismissals Hide Opportunities in the Aerospace Industry
Posted by: Vanin Aegea (IP Logged)
Date: November 4, 2013 09:18AM

Defense contractors have been sailing turbulent waters since the initiation of the sequester and the following government shutdown. Some have fared the storm better than others thanks to the characteristic of their products, rising civil applications or the priority given by the Department of Defense. Lockheed Martin (LMT) and General Dynamics (GD) are two of the most important defense contractors, but merchandise differences portray very different outlooks for each of them.

High Priority and Growing Backlog

The full impact of defense budget cuts upon the overall performance of Lockheed Martin cannot be predicted. However, telling evidence can be found in quarterly reports and news headlines. For example, on Oct. 4 [size=11px; line-height: 13px], [/size]announced that 3,000 employees will be affected by furloughs due to the federal government shutdown. At the same time, the few contracts that become available are characterized by fierce battling, as seen around the replacement of Canada’s fighter jet between Lockheed Martin and Boeing.

The Canadian contract represents a great opportunity for Lockheed Martin to diversify its portfolio and offset the weight represented by the Department of Defense and other U.S. agencies. Currently, only 18% of total sales is made outside the U.S., while 61% is directly associated with the Department of Defense.

Another downside is the continued delays of the F-35 new stealth fighter jet, consequently raising sale tag price and reducing backlog orders. Last, the information technology segment has been able to curve budgetary cuts, but no increments have been registered after 18 years of continued growth.

Amid all the difficulties the industry is facing, Lockheed Martin was able to post strong results for the third quarter. Backlog has increased together with earnings, and sustained a strong cash flow in the midst of a revenue decline. The Intelligence Surveillance Reconnaissance (ISR), unmanned systems, force protection, cyber security and missile defense programs are expected to drive growth due to the priority placed upon these products by U.S. authorities. At the end of the second quarter, backlog amounted to an estimated $75.1 billion.

Financially, Lockheed Martin is strong as operating margins continue to improve. Currently trading at 14.4 times its trailing earnings, the stock carries a 27% discount to the industry average. And the largest guru holding a position in the company, Jean-Marie Eveillard, continues to increase his stake. I share his optimism because the firm has curved budget cuts through improved operational efficiencies, the priority placed upon its products and increasing backlog.

Capacity Adjustment and Declining Revenue

General Dynamics announced that 23 employees from its Springboro facility were laid off on Nov. 1. It is not the first time the company dismissed employees during the current year, continuing a trend started last year. The restructuring plan has so far claimed the jobs of 35 employees at Williston this year, in addition to 80 employees between the facilities at Vermont and Maine last year and 67 at Canadian facilities, among others. In total, the internal restructuring and adjustment plan is estimated to have cut personnel by 10% in the last two years.

Layoffs, however, are only half of the story about General Dynamics. The last report had strong results that reflected steady orders, and earnings and sales increments amid declining revenues. Another positive sign towards the future is that revenue exposure is spread over a broad portfolio of products and services. But the most important catalyst to the firm is the steady performance of its Gulfstream commercial jets. The G650 model (largest commercial jet in the industry) has been very well received by the market, and there is so far a five-year backlog.

Growth for General Dynamics is heavily dependent upon the performance of the Information Systems & Technology segment. Given a steady year-over-year decline in total backlog, prospects for growth are dim in the best case. Also, the cyclicality of the smaller commercial jet risks to offset the backlog created for larger models. Last, servicing and replacement of Abrams tank is not expected to be done any time soon, and the projects in the marine segments are expected to suffer from delays.

The balance sheet for General Dynamics is strong even with a rising debt related to recent acquisitions. Currently trading at 12 times its forward earnings, the stock carries a 36% percent discount to the industry average. Interestingly enough, James Barrow turned into the guru with the largest position, making a single transaction during the second quarter of 2013. I do not share his optimism since management has indicated that further capacity reductions are expected in Europe, while revenue is expected to decline 15% versus the earlier estimate of an 8% decline.

Layoffs Are a Symptom, Not the Sickness

Layoffs are common in the defense industry these days and show the dark side of the industry. However, they are only a symptom of a major problem that can be found at government budgetary allocation and portfolio diversification. I prefer Lockheed Martin over General Dynamics because the priority given to its products have helped it curb budget cuts. Also, its information technology segment is set to benefit from a greater emphasis on surveillance by national authorities.

Disclosure: Vanina Egea holds no position in any of the mentioned stocks.

Guru Discussed: James Barrow: Current Portfolio, Stock Picks
Stocks Discussed: GD, LMT,
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