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Analysts Review QDR's Impact on Industry

WALL STREET, New York --- The Wall Street Transcript has just published its Aerospace and Defense issue, a report offering a timely review of the sector to serious investors and industry executives. This 38 page feature contains interviews with 3 leading industry analysts and industry insight from top management from 6 firms.

Topics include: Commercial airline orders, Impact of domestic airline difficulties, Outlook for defense spending, military transformation, Homeland Security, high oil prices, Budget deficits, Industry investment outlook, recommended stocks, Stocks to avoid.

1) In the following brief excerpt from the 38 page report, Troy Lahr discusses the impact of the Defense Review and the outlook for the sector and for investors.

TWST: What's likely to come out of the Defense Review?

Mr. Lahr: Most likely there is going to be redirection of resources focusing more on counterinsurgency warfare, such as what we are facing in Iraq and Afghanistan right now; that would be, more or less, getting away from the big ticket programs like your big ships, aircraft and things like that. We think that is going to be the case. However, that's probably a long-term issue. You might buy fewer destroyers or the DoD may need fewer carriers down the line. But near term, I don't think you are going to see any major shifts. Particularly with Lockheed Martin, for example, in the aircraft fleet, the question is, are they really going to need 2,500 Joint Strike Fighters? I do think they need a lot, but whether they need 2,000 or 2,500 is unknown. We think it's going to have a marginal impact long term on Lockheed Martin. Any program cuts on these big ticket programs will probably come beyond 2010, so we think we'll be fine in the near term.

TWST: It sounds like a lot of political gamesmanship will continue to go on then.

Mr. Lahr: Yes, you really do see that. Contractors know that, and so they spread these programs out over a wide variety of congressional districts. We saw that in the last budget cycle. The President tried cutting some money out of the defense budget for particular line items and trimming certain programs and Congress actually came back and added the programs back and even plused up the budgets on several particular programs. Take the C-130J, for example, a Lockheed Martin cargo aircraft; the DoD canceled the program and Congress turned around and reinstated it and plused up the budget. So we see that really Congress has the final say.

TWST: Business as usual?

Mr. Lahr: Yes, it really is, even though it's kind of surprising. Another example is, the Navy doesn't want any additional funding for DDG 51's. It's kind of a Reagan-era Cold War destroyer. They don't want it anymore. However, there are a lot of jobs tied up in that program so Congress said no. So they threw two more in the budget. It's funny how it works.

TWST: What are you telling investors to do in the space at this point?

Mr. Lahr: I still think there are ways to pick and choose in the industry. We still like Lockheed Martin; that's our best large cap idea. Again, it's a good diverse portfolio that they have. It's not just aircraft. Tactical aircraft, F-35 and F-22 make up about 15% of total sales. The remaining 85% of the businesses is in electronics, intelligent systems, space, IT, so there is a very good mix there.

Also when you want to get into the defense industry, you want to focus on companies that have strong execution. You don't want to focus on a company or, better yet, you really want to stay away from companies that have execution problems because those programs are most in jeopardy of getting cut.

Another way we look at it is on the small cap side, where we like Orbital Sciences. It's a very niche type company. They do missile defense work and also satellite work for science and military customers.

TWST: What's number two on your list?

Mr. Lahr: Large cap is still Lockheed Martin, but the top pick in my space right now is Orbital Sciences. There really are a lot of misperceptions surrounding the name. It is a small cap name, $750 million market cap; the stock has done really well over the past few weeks since we picked it up, but it's still significantly undervalued and it operates in niche markets. So it's attractively valued right now.

The problem with Orbital Sciences, people don't understand that they are really not going to pay cash taxes until about 2018 or 2020. So they are valuing it on GAAP earnings, and they had an accounting change in 2004 versus 2005. I think investors are inappropriately valuing this company. They were in a lot of satellite ventures a few years ago and that's where they created all these losses, but today's investors get the benefit from that. Overall, it's a very good company with niche markets, and the misperceptions can be an advantage to more knowledgeable investors.

TWST: Where are the big opportunities for Orbital?

Mr. Lahr: Missile defense interceptors. They are on a lot of programs. They've competed with Boeing (BA) and Lockheed Martin and they've actually been able to win business from them. They were originally a rocket manufacturer, and they've been able to leverage their rocket manufacturing abilities over to missile defense interceptors. They have a really good program there. They are on the Boeing Ground-based Midcourse Defense missile program. They are doing work on Kinetic Energy Interceptors. They also are working on satellites for NASA, the DoD and the intelligence agencies. Probably, the biggest catalyst right now for Orbital Sciences, if the Lockheed Martin team can win it, is the Crew Exploration Vehicle, which is coming up probably in March. If the Lockheed team wins that, Orbital Sciences would probably pick up about 5% of the $15 billion development contract, which would just be a huge win for a small cap company like this. Right now, we still think the Boeing-Northrop Grumman team is the favorite, just due to their past work on the space shuttle. But I definitely wouldn't discount Lockheed Martin and their work on the program.

TWST: Is there a third name?

Mr. Lahr: The last name probably is Raytheon. Of the large cap defense names, they probably have the least program risk. The company has done a good job of turning around the businesses under the CEO, Bill Swanson, who has been around probably about two years now. He has done a good job of focusing on execution. The company is really, I think, undervalued here. I like the products that target end-markets such as intelligence, surveillance, reconnaissance, missile defense work and precision munitions.

2) In the following brief excerpt from the 38 page report, Peter Arment discusses the brighter prospects for both the commercial and defense sectors, and the outlook for investors.

TWST: On the commercial side, can the industry have a pickup when these airlines are in such bad shape?

Mr. Arment: Yes. The spike in oil prices can accelerate an airline's plan to retire older higher fuel burning planes and supplement them with newer efficient aircraft. With jet fuel comprising 15%-20% of an airline's operating costs, a younger and more fuel efficient fleet can be a significant competitive advantage. The airlines that have the financial wherewithal, which have primarily been profitable low-cost and international carriers, continue to order planes in order to meet capacity needs. For the domestic majors, it is a totally different ball game.

Our thesis regarding a recovery on the commercial aerospace cycle is being led by international and low-cost carriers. We do not anticipate any significant domestic participation in terms of orders until at least 2007. So over the near term, we believe the airliner up cycle can remain intact without domestic participation.

TWST: What is the outlook on the military side, the government side?

Mr. Arment: Status quo. Defense outlays should remain at relatively high levels. Are we getting the double-digit increases in defense spending that we experienced in 2003 and 2002? No. But GDP-plus type growth for the overall budget for the next few years is very likely. Many programs are seeing production increased over the next few years, so the growth may be more favorable among a few individual defense contractors.

TWST: Where is the money going, given this military transformation that Rumsfeld keeps talking about?

Mr. Arment: Lots of electronics. We are digitizing the battlefield, improving communications between all the different platforms, enhancing our reconnaissance capabilities and upgrading and/or replacing legacy platforms. But the common theme is this all requires more electronics to achieve a significant part of the transformation efforts. At the same time, the DoD wants to remain at the forefront of developing next generation technology so major R&D efforts have been under way for several key national security programs, i.e., missile defense, DD(X), Joint Strike Fighter and the Future Combat Systems.

TWST: Does this transformation process or program put any of these old programs at risk?

Mr. Arment: You are going to need to maintain your legacy base, especially when you have ongoing operations on a global basis. We are extending the life of some of these legacy programs through upgrades, which could push out the production of some of these newer more expensive programs. We expect to hear some details this fall regarding the potential upcoming changes in the FY07 budget to be released in February 2006.

TWST: So the shifting in emphasis to electronics isn't going to affect the next generation of fighter planes or ships?

Mr. Arment: As I just mentioned, we will be seeing their next strategic review called the Quadrennial Defense Review or QDR in February 2006 at the same time as the President's 2007 budget request, which will be reviewing the long-range planning for military capabilities and system requirements. Electronics does not impact a next generation platform in that regard. The QDR will outline the direction of next generation systems.

The QDR focus is expected to be on asymmetric warfare capabilities, which is for countering insurgency, which we are seeing in Iraq and Afghanistan, and force protection needs, which is protecting our troops. Both of these areas have not been emphasized in previous reviews. Addressing budget and deficit pressures is also part of the QDR.

TWST: What is at the top of your buy list at this point?

Mr. Arment: On the commercial side, we continue to recommend Boeing, but a related supplier that has been a very strong performer and we continue to like is Precision Castparts (PCP). PCP has had a very strong performance year to date of up over 45%, and we think there is at least another 30% upside by the end of next year. That's due to a combination of higher OEM deliveries at Boeing and Airbus and a healthy spare parts aftermarket business. For example, a core product area for PCP is making blades and vanes that are inside aircraft engines. As the industry experiences higher aircraft utilization rates (more take-offs and landings), there is more wear and tear on these parts. Double digit organic growth should remain intact for the next several quarters, which should translate into further gains in the PCP stock over the next 18 months.

Another name on the commercial side that we like is a smaller cap, AAR (AIR). That has been another strong performer, up 30% year to date. Here the investment theme is more a pure play on airline outsourcing. They are a leading independent third party maintenance, repair and overhaul (MRO) company that serves airframes, landing gear and components. They also provide inventory management programs for airlines. These areas within an airlines' budgets are all being targeted to be outsourced due to the high internal cost. Airlines are trying to focus only on transporting people. When you see a new airline start up, the model is to outsource. They never build out the internal capability such as heavy maintenance. JetBlue has limited maintenance, repair and overhaul capabilities. They outsource as much as possible. The newer airlines are really providing the blueprint and the domestic majors are trying to replicate it. AIR is already a beneficiary of this initial outsourcing.

TWST: Those were two good names. Have you got a third?

Mr. Arment: I would like to highlight a company like L-3 (LLL), which is a defense play that is really focused on defense electronics. Electronics, not platforms, provide higher growth opportunities and returns on investment. LLL is also a leading homeland defense play with $800 plus million in annual sales tied to homeland security. It has a high exposure to classified programs where you are seeing much higher rates of growth within the defense budget.

Additionally, they are also an acquisition machine that provides significant external growth. They have made a few dozen acquisitions over the last five years and they have really been the leading consolidator of the tier-one, tier-two, tier-three suppliers within the defense industry. Their last acquisition, and largest, was a $2.7 billion acquisition of Titan Corporation which closed roughly a month ago. That really broadened their classified capabilities in the IT and secure communications world. Titan is going to prove to be a very attractive platform for further consolidation opportunities within the smaller, niche-oriented companies that are supporting a lot of the government IT-related services. The top and bottom growth for 2006 is going to be above 20%. We have a price objective of $115 for the end of 2006 and we are currently at $81. That represents about 41% upside over the next 18 months.

TWST: Any other names to highlight?

Mr. Arment: Alliant Techsystems (ATK). ATK is the leading manufacturer of conventional ammunitions in the US. They also have heavy exposure within precision weapons and are the leading producer of solid rocket propulsion motors. Many investors view them as just a play on the Iraq War, given the consumable nature of munitions. But missile defense, the Space Shuttle and composites products are also providing a boost in growth. ATK has been a steady performer and has a very shareholder-friendly respected management team. They generate a lot of free cash, with which they are buying back stock and de-leveraging their balance sheet. Over the next 18 months, we believe there is probably at least 20% upside in ATK. It's a strong mid-cap defense name.

3) In the following brief excerpt from the 38 page report, Eric Hugel discusses demand for commercial planes and the outlook for the sector and for investors.

TWST: What has gone on in this space from a market perspective so far this year?

Mr. Hugel: You really have to look at the two different markets independently. On the commercial aerospace side, it's been very positive in terms of ramping back up the commercial aerospace demand cycle, despite some pretty significant increases in oil prices. Demand from the traveling public, on a global basis, continues to hit new highs, prompting airlines on a global basis to add capacity. Over time, this additional capacity increases their need to service those airplanes that are flying, take airplanes out of the desert and bring them back into service, and buy new airplanes. All of these are positives for the commercial aerospace supplier base.

Especially in light of high oil prices, there is a strong demand for newer more efficient aircraft such as the A380 and A350 from Airbus and the Boeing 787. Low-cost airlines continue to buy a lot of B737 and A320 family aircraft. This trend has prompted a pretty significant positive response from the investor base. It is a question of whether or not the economy, on a global basis, is going to continue to do well and prompt people to continue to travel, and continue this cycle. Are the airlines going to continue to be able to finance these aircraft that they currently have on order or plan to order? Everyone wants to know when the peak of the cycle will be reached so they can sell these stocks about a year to a year and a half ahead of that peak.

TWST: Given that, what are you telling investors to do at this point?

Mr. Hugel: We are very positive on most of our commercial aerospace names. Again, we think the peak of the cycle is probably the 2008, 2009 time frame. We believe that the ensuing downturn is likely going to be mitigated. We think that creates a positive environment right now for these stocks. Even though the multiples are pretty high right now, there are still significant amounts of upside potential to earnings expectations. The balance sheets and the cash flow out of most of these stocks are pretty positive, and there should be a nice amount of acquisition growth potential to boost the growth rates.

On the defense side, we are on the sidelines of most of our names here. We do like Northrop Grumman. In terms of a multiple, it is currently trading at its lowest, and we believe that it is an attractive large cap name to get nice exposure to C4ISR, UAVs, information technology and space, where the focus of defense dollars are headed.

TWST: Is that your top pick at this point?

Mr. Hugel: My top picks would probably tend to be more on the commercial aerospace side, and they would be Precision Castparts, Curtiss-Wright and probably BE Aerospace. These stocks are currently more in favor; thus, we believe they provide greater near-term upside potential.

TWST: What's at Precision that you like?

Mr. Hugel: A very good, solid, top-notch management team. They are a low-cost manufacturer. They have a constant focus on driving cost out of their business. They've managed to go through the last downturn by giving their customers, the engine OEMs, the GEs of the world, the pricing concessions that they wanted in exchange for long-term market share guarantees. So now, during the upturn, we are seeing that they are growing faster than the overall market rate because not only are they benefiting from production rate increases and increased volumes of aircraft coming in for engine overhaul and repair, but they are also benefiting from increased market shares on those engines.

You have a couple of acquisitions that the company has done that have been very synergistic. With the SPS acquisition, they have been able to take significant amounts of cost out of the business and deliver to shareholders a nice amount of upside to earnings expectations. They just announced another acquisition, Special Metals Corporation, which we believe has significant opportunities to deliver additional significant upside to earnings estimates and additional accretion above what management is currently forecasting as they integrate this operation. Precision Castparts is one of the largest users of nickel for producing forgings for complex end use industries such as aerospace. Special Metals Corporation is a nickel-based alloy producer. There are significant amounts of cost synergy opportunities there for them to not only source metal from Special Metals Corporation so they don't have to pay the markup, but to leverage the fixed assets of that company by combining PCP's internal demand for these metals over SMC's existing sales. Given that PCP does not currently source a significant amount of nickel alloy from SMC and that PCP is perhaps the largest user of such alloy in the world, we believe that the leverage could be substantial.

We believe that Curtiss-Wright is an undervalued company here. We think it has a solid management team. The stock has been taking a multiple hit, given some inconsistency in reporting earnings in line with Street expectations. Going into the back half of the year, they are going to gather momentum as they deliver a significant amount of military orders on top of benefiting from strong commercial aerospace markets. They have leading market shares across most of their revenue base. They have strong exposure to nuclear power and oil and gas processing, which, given today's high oil and gasoline price environment, are becoming increasingly attractive. Longer term, as a sole source supplier of nuclear reactor pump and valve technologies to Westinghouse Air Brake Technologies (WAB) and GE (GE), they could be a nice beneficiary of China building new nuclear power plants. We think that there is still nice upside potential remaining in the stock.

We like BE Aerospace in that BE is really a pure-play on the recovery of commercial aerospace and the biz jet markets. It is a play on the increased focus among airlines of international long-haul travel. If you think about the amount of interior content, seats, ovens and such, the amount of content on a wide body is significantly more than on a narrow body. Really, you are seeing significant growth in demand for wide-body aircraft out of the Asian airlines. You are also seeing significant demand for retrofits of existing aircrafts out of Asia. We believe that a significant opportunity exists from major US airlines that haven't really invested a significant amount of money in their long haul fleets because of their financial troubles. At some point, they have to put money into their fleets to remain competitive or else they will lose that business. (ends)

The Wall Street Transcript is a unique service for investors and industry researchers - providing fresh commentary and insight through verbatim interviews with CEOs and research analysts. This 38-page special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

The Wall Street Transcript does not endorse the views of any interviewees nor does it make stock recommendations.

Defense Review Impact on Investors a key topic of Wall Street Transcript Aerospace/Defense Report