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Trump cost-cutting crusade doesn't dim optimistic outlook for US defense sector

F-35C aircraft as seen from deck of the USS George Washington in August 2016 during testing off Virginia coast.
Source: US Navy
F-35C aircraft as seen from deck of the USS George Washington in August 2016 during testing off Virginia coast.

America's top military contractors have literally been playing defense against Donald Trump, trying to shore up support for key contracts just as they are preparing to report fourth-quarter earnings.

Trump has used his bully pulpit as president-elect to criticize large contractors for program delays and costs he considers out of control, and it has meant Lockheed Martin and Boeing investors have seen occasions when those stocks felt the jabs.

"Even when you have contracts in place, there's going to continue to be pressure to execute on time, on budget and deliver even more than you promised," said Moody's analyst Russell Solomon, who covers the aerospace and defense industry.

The CEOs from Lockheed and Boeing have met separately with Trump in an attempt to allay his concerns about certain contracts.

Trump has criticized Lockheed's F-35 stealth fighter program, including during his Jan. 11 press conference when he said the F-35 is "way, way behind schedule and many, many billions of dollars over budget." Lockheed stock slid as much as 1.8 percent the day he took the swipe — and it wasn't his first time going after the aircraft.

Indeed, Trump's first slap at the F-35 was tweeted on Dec. 12, when he lashed out at the program's "out of control costs." Lockheed shares slidmore than 4 percent in early trading that day.

As for Boeing, Trump tweeted Dec. 6 about its new 747 Air Force One aircraft: "costs are out of control, more than $4 billion. Cancel order." Boeing stock fell as much as 1 percent in premarket trading that day but did manage to recover.

Given Trump's eagle eye for defense program spending, there is a possibility of new acquisition reform inside the Pentagon, and that could hurt contractor profitability.

"We think President Trump will continue to be outspoken on better pricing for defense programs with cost overruns, publicly encouraging companies involved to cut costs," Credit Suisse said in a research note Thursday. "While this greater emphasis on cost controls could result in a temporary dislocation of share prices, it is still very unclear how effective a Trump administration could be at reforming the acquisition process and adversely impact pricing and margins on certain programs. Even if there is some success on this front, it likely would not flow through to contractor financial results for some time."

There also are other reasons to be positive about the sector, according to analysts.

"Our DC discussions reaffirmed our view that there is strong consensus for higher levels of defense spending, although the mechanics to undo sequestration (Budget Control Act) are still to be determined," UBS analyst David Strauss said in a note Wednesday.

Analysts say obsolescence with some of the older equipment in the military arsenal is driving a portion of future spending as well as Trump's overall pledge to rebuild the armed forces.

"In the last defense spending cycle, I think we underinvested," said Richard Safran, Buckingham Research Group director of equity research. "We're playing a little catch-up ball in this spending cycle."

Safran expects the sequestration budget caps will be repealed to help fund some of the increased defense spending. Trump has already said he will ask Congress to do just that.

Overseas demand strong

Another positive trend for the American defense contractors is that overseas demand remains strong for missile systems, aircraft, radar technology and other military hardware.

"Geopolitical risk is certainly not slowing," said Moody's Solomon, pointing to the Middle East, Europe and Asia/Pacific markets. In the case of Europe, NATO allies are under pressure to do more burden sharing of defense while also spending more to combat terrorism.

For Lockheed, the company has seen growing demand internationally for its defensive technology, including its Aegis naval weapons system in Japan and South Korea, while its THAAD missile defense systems are of interest in countries like Qatar and Saudi Arabia.

Lockheed first out of the gate

Lockheed is scheduled to report fourth-quarter earnings on Tuesday, making it the first of the five major defense primes out of the gate. The world's largest defense contractor has beaten the Street on earnings per share in all but two of the last 15 quarters, according to FactSet.

Analysts expect the company to report earnings of $3.05 a share on revenue of $13.03 billion, according to Thomson Reuters.

Trump's comments on the F-35's costs add to uncertainties for Lockheed and are likely to be a key topic on the minds of investors during the company's earnings call. Trump has mentioned that Boeing's fourth-generation F-18 Super Hornet fighter jet could be used as an alternative to the F-35, a fifth-generation stealth fighter.

Lockheed is the main contractor on the F-35. Other companies participating in the program include Northrop Grumman and United Technologies' Pratt & Whitney business. The program is forecast to cost the Pentagon upwards of $1 trillion over its 55-year life.

The first F-35 delivery of 2017 was the 200th overall delivery and made to Japan, one of the original nine partner nations buying the aircraft. Israel, which is buying 50 of the fighters, received its first deliveries in December.

Besides its exposure to the F-35 fighter, Northrop also has the B-21 Raider, a long-range strike bomber program. So far, the B-21 program, which could cost upwards of $80 billion, has been spared Trump's cost-cutting crusade.

Northrop is scheduled to announce its December quarter earnings on Thursday — the same day Raytheon is set to report. Northrop's EPS is forecast to be slightly above a year ago and consensus has been trending higher in the past 90 days. Guidance for 2017 also is expected be provided on the earnings call.

According to Thomson Reuters, Northrop is expected to post earnings of $2.49 a share on revenue of $5.93 billion.

As for Raytheon, it has reported surprise upside earnings in 11 of the last 12 quarters and its strong international business should boost its fourth-quarter results. There also remains strong demand globally going forward for its air and missile defense systems such as the Patriot, radar surveillance as well as its encryption devices and cybersecurity solutions.

According to Thomson Reuters, Raytheon is expected to report earnings of $1.86 a share on revenue of $6.56 billion.

Commercial planes could ding Boeing earnings

Boeing's fourth-quarter results are scheduled for Wednesday. Consensus EPS for the December quarter has been trending lower in the past 90 days. Analysts now expect the company to report $2.35 a share earnings on revenue of $23.19 billion, Thomson Reuters said.

Boeing's international military business could see a boost in the quarter as the U.S. government late last year approved two major foreign aircraft deals together valued at more than $30 billion.

Even so, Boeing is seeing weaker-than-expected orders in its commercial airplane business, due in part to more competition from Airbus. Boeing has said it plans to reduce the commercial side's spending in 2017, and that includes job cuts.