Defense Pros Miss India, What Next?

French conglomerate Dassault Group’s Rafale combat jet emerged as the lowest bidder for the multi-billion contract for the Indian Air Force. The $10.4 billion deal is for supplying 126 medium multi-role combat aircraft to the Indian Air Force (‘IAF’). The order heralded Rafale’s entry into the export market.

Rafale’s entry into the export market is a major bad news for the beleaguered U.S. defense contractors who are looking offshore to compensate for the Pentagon’s planned axing of almost $1 trillion in budget cuts over the next decade. Although defense primes have mostly reported upbeat numbers for fiscal 2011, we are concerned about future growth in order backlogs from domestic programs.

Rafale emerged the winner beating five contenders and arch-rival Eurofighter Typhoon. Eurofighter Typhoon is a twin-engine, canard-delta wing, multi-role fighter. Eurofighter Typhoon was developed by a consortium of three companies – The European Aeronautic Defence and Space Company N.V., Alenia Aeronautica and BAE Systems.

U.S.defense goliaths Lockheed Martin Corporation’s (LMT - Analyst Report) F-16 Falcon and The Boeing Company’s (BA - Analyst Report) F-18 Hornet were also in the fray. The rest of the contenders were Russian Aircraft Corporation MiG’s MiG-35, and Swedish aerospace and defense company Saab AB’s Saab JAS 39 Gripen.

However, in November 2011, citing technical reasons the list was pared to two consisting of only Rafale and Eurofighter Typhoon. U.S. defense primes have now shifted their focus on a planned $5 billion purchase of fighter jets by Brazil. 

The perplexity is writ large among the defense primes. For example, Boeing, in a conference call last week, pinned its top-line growth to overseas prospects. The company currently generates close to one-eighth of its topline from export sales which the company expects to increase to more than a fourth over the next few years.

Likewise, Lockheed Martin, the world’s largest stand alone defense company, is facing bottlenecks at the F-35 program. The F-35 is the Pentagon’s biggest weapons program, at an estimated cost of $382 billion for development and the purchase of planes.

Pentagon with constrained budgets is reducing and delaying future purchase of F-35 jets. Defense Secretary Leon Panetta is pushing for 13 fewer F-35 in the fiscal 2013 budget and 33 less in the fiscal 2014 budget.

Any downside on the F-35 program is a bad news for another defense biggie Northrop Grumman Corporation (NOC - Analyst Report) which has substantial exposure to the program on account of its role as a subcontractor. Apart from that prominent Northrop programs like the unmanned aerial vehicle Global Hawk program are increasingly coming under the scanner for potential targets for budget cuts.

L-3 Communications Holdings Inc. (LLL - Analyst Report) may also face margin headwinds going forward on account of two significant contract re-competition in its services business.

On the other hand Raytheon Company (RTN - Analyst Report) which generates more than a third of its top line from export sales is on a more solid footing from its wide exposure in focus areas like cybersecurity; missile defense; intelligence, surveillance and reconnaissance; and electronic warfare.

Overall, in the past week, the Defense & Aerospace firms (we monitor actively) with an average beta of 0.8% rose 0.3%, on average, outpacing the performance of the S&P500, which fell 0.2% over the same period. However, contrary to trends Huntington Ingalls Industries, Inc. (HII - Snapshot Report) posted double-digit return over the past week.

The rise is a misnomer to the industry as Huntington rose solely on the premise of timely overhaul of the Lincoln Carrier ship. However, we are on the sidelines for the company owing to the fact that its performance is heavily tied to U.S. defense.

Also in the current uncertain economy, bonds and high dividend paying stocks come foremost in the minds of investors. However the average dividend yield of 2.1% for our actively tracked defense stocks is close to the S&P 500 yield which is currently at 2.2%.

Out of this prominent among them is Lockheed Martin with yield hovering close to the 5% mark. In contrast, the 10-year Treasury bond currently returns approximately 1.8%.

Our guarded outlook is reflected in our long-term Neutral ratings on U.S. based defense operators like Lockheed Martin, Boeing, Northrop Grumman, Raytheon, General Dynamics Corp. (GD - Analyst Report), L-3 Communicationsand United Technologies Corporation (UTX - Analyst Report).

Read the full analyst report on NOC

Read the full analyst report on BA

Read the full analyst report on RTN

Read the full analyst report on GD

Read the full analyst report on LLL

Read the full analyst report on UTX

Read the full analyst report on LMT

Read the full analyst report on HII