High earnings for defense sector as budget cuts loom

Some of the nation’s largest defense companies are seeing a boost in their quarterly earnings amid uncertainty over the Pentagon’s future priorities.

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In a surprise to Wall Street, Lockheed Martin, General Dynamics and L-3 Communications posted stronger-than-expected second-quarter revenues and profits, but some defense analysts view the strong results as the calm before the storm.

Deficit worries in the Pentagon and Congress have led the Defense Department to launch a savings exercise, and eventually could lead to lower defense spending that would affect many of the companies reporting profits today.

Investors are already sensing some downward trends in the defense industry, leading to depressed valuations of defense firms, analysts point out.

Defense companies “have another year or two of good times ahead, but after that there is no mistaking which way defense is heading both in total [spending] levels and margin pressures,” said Richard Aboulafia, vice president of analysis at the Teal Group.

“Right now there is still a lot of cash washing through the system from the record levels of defense spending,” said Aboulafia. “The companies still have at least a year or two of that cushion.”

Lockheed Martin, the nation’s top defense company, this week reported its second-quarter earnings were up 12 percent compared to last year. Lockheed reported earnings of $825 million, or $2.22 per share, up from $734 million, or $1.88 per share, at this time last year. Revenue rose 3 percent, to $11.44 billion.

L-3 Communications reported a 2 percent increase in net income. In its second quarter, the company earned $227 million, or $1.95 per share, compared with $223 million, or $1.90 per share, a year ago. However, L-3 cut its 2010 outlook because the company lost one contract and had debt retirement charges.

General Dynamics, another defense giant, on Wednesday reported second-quarter net income of $648 million, or $1.67 per share, compared to $618 million, or $1.60 per share, in the same quarter last year. The company’s second-quarter profit rose 4.9 percent. The company also raised its full-year earnings forecast given its wider operating margin.

In an exception from the otherwise positive reports, Boeing’s quarterly earnings report showed a sharp decline. The aerospace giant reported weaker-than-expected earnings in its military business for the second quarter.

Boeing’s defense unit suffered a 24 percent fall in revenue from its network and space systems business, but the company’s military aircraft sales rose by 4 percent.

Though margins stayed strong for a number of larger defense contractors, some subtle trends are beginning to develop that are starting to erode investor interest in defense stocks, said Jim McAleese of McAleese and Associates.

“There are aberrations that are happening,” McAleese said. Some companies are starting to miss their sales targets, or the new orders coming are less than expected, he explained. Additionally, concerns over specific programs could prevent investors from buying stock, he said.

For example, Lockheed Martin is working to recover from troubles with the F-35 Joint Strike Fighter program, the Pentagon’s largest endeavor.

The Air Force temporarily suspended L-3’s Special Support Programs unit in June, citing allegations that the unit had improperly accessed government computers to collect business intelligence.

The company announced on Tuesday that it had reached an understanding with the Air Force to have the suspension lifted.

Major defense companies that have enjoyed banner revenue and profit for nearly a decade are now publicly backing a new Pentagon effort to make contracts more affordable and eliminate unnecessary spending on weapons and services. Pentagon leaders are seeking to find $100 billion in savings over the next five years that would be poured into the fighting force and modern weapons systems.

Before the Pentagon’s announcement, defense contractors such as BAE Systems, Lockheed Martin, Raytheon and Boeing had announced hundreds of layoffs because of program cancellations and in anticipation of leaner times.

Defense insiders viewed the layoff announcements as a sign that military contractors are girding for leaner times and responding to their shareholders.

Defense companies, responsible to their stockholders, must keep profits high enough to compete for capital as they anticipate reductions in the defense budget.

Earlier this month, Lockheed announced a new effort intended to reduce overhead and improve affordability by reducing the number of leaders at the director and vice president levels.

The effort basically aims to keep pace with the Pentagon’s increased focus on affordability and efficiency as the Pentagon undertakes its belt-tightening measures.