Aerospace Still Flying; Subprime Hitting Insurers

Aerospace continues to be the best ranked sector.

Most of the Zacks #1 Rank ("strong buy") and Zacks #2 Rank ("buy") stocks within this sector derive a significant amount of their revenues from government spending. Two ongoing wars and a sustained focus on homeland security are providing a boost to revenues and earnings for aerospace and defense companies.

Although companies like Lockheed Martin (LMT) and Northrop Grumman (NOC) are very dependent on defense spending, there are companies within this group that also do a large amount of commercial business, such as FLIR Systems (FLIR).

FLIR designs and manufactures thermal imaging and infrared camera systems. The company's products are used both for surveillance and industrial applications, such as leak detection.

FLIR generated revenues of $242.6 billion in the fourth-quarter, an increase of 31%. (Approximately 47% of sales came from the company's Government Systems' division). Adjusted earnings totaled 30 cents per share, matching expectations.

The company expects the favorable conditions to continue and guided for 2008 earnings between $1.13 and $1.20 per share. Nearly all of the covering brokerage analysts raised their forecast in response, sending the consensus earnings estimate seven cents higher to $1.18 per share.

FLIR is a Zacks #1 Rank stock and is classified in Electronics-Military Systems. LMT and NOC are Zacks #2 Rank stocks and are classified in Aerospace/Defense.

Shares of American International Group (AIG) plunged to a five-year low on Tuesday because of subprime fears.

An SEC filing revealed that the company's model underestimated losses for its AIG Financial Products Corporation and AIG Trading Group subsidiaries (referred to collectively as AIGFP). The revised numbers showed a potential $5 billion loss in November, versus a previously disclosed $1.6 billion decline in valuation.

Yesterday, AIG responded by stating, "Any losses AIGFP may realize over time as a result of meeting its obligations under these derivatives will not be material to AIG".

So far, the fourth-quarter consensus estimate for AIG is largely unchanged in reaction to the new filing. The consensus earnings estimate calls for the insurance conglomerate to have earned $1.38 per share. This forecast is down two cents from a week ago. The most accurate estimate is more bearish at $1.37 per share. The company will likely report on Feb 28. AIG is a Zacks #3 Rank ("hold") stock.

AIG is not the only insurer to be tied to the subprime crisis. Last week, Genworth Financial (GNW), Lincoln National (LNC) and Principal Financial Group (PFG) all reported write-downs caused by the subprime crisis. GNW incurred a loss of $93 million, LNC wrote down $193 million and PFG realized a loss of at least $57 million. LNC is a Zacks #5 Rank ("strong sell") stock and GNW and PFG are Zacks #4 Rank ("sell") stocks.

So why are insurers being affected by subprime?

The answer requires an understanding of their business models. Insurers use actuarial models to determine what future claims may total. Based on these models, claims risk for each client is assessed and a premium is determined. (The higher the risk, the higher the premium.) These premiums are invested so that money paid in can grow over time.

In investing the premium payments, an insurer seeks to accomplish two goals. The first is to provide an extra source of income in addition to the premiums. The second is to ensure that an adequate balance of cash is available each year based on the expected level of claims. Therefore, insurers seek a combination of stocks (long-term growth) and bonds (short and mid-term income).

Given the size of their portfolios and the varied timing of claim payments, insurers need to diversify across various assets. Part of this diversification includes asset-backed securities, which typically pay a higher level of interest. While diversification does help returns over the long-term, the current environment and the structure of some subprime and ALT-A related securities is hurting the portfolios of multiple investors, including insurers.

I previously warned that insurers could be adversely affected by the subprime crisis and thus I'm not surprised to see some companies reporting declines in their investment income. I also think it is probable that the credit crunch will impact first-quarter earnings for these companies.

The trend in earnings estimate revisions supports my hypothesis. During the past four weeks, more estimates have been cut than raised on companies within Insurance-Life, Insurance-Multiline and Insurance-Property/Casualty.

Zacks Premium and ZacksElite subscribers can view the Zacks Industry Rank List at http://www.zacks.com/zrank/zrank_inds.php. This interactive list allows you to see all of the companies, and their Zacks Rank, within more than 200 industries. Shown below is the Zacks Sector Rank List, which shows the trend in estimate revisions on a broader scale.

Charles Rotblut, CFA, is the senior market analyst for Zacks.com. He can be reached at crotblut@zacks.com

Read the full analyst report on NOC

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Read the full analyst report on FLIR

Read the full analyst report on GNW

Read the full analyst report on PFG

Read the full analyst report on AIG