Performances of companies in the aerospace and defence sector - mixed for some time to come

US EQUITIES
• Recommendations update
Performance of companies in the aerospace and defence sector should be mixed for some time to come. We believe companies with large defence exposure should do well, while companies with larger exposure to commercial aerospace should underperform as long as airlines remain weak. However, potential issues such as bankruptcies and terrorism could pressure the entire sector. Nonetheless, we have a BUY rating on Northrop Grumman Corp. (NOC, $82.73, CSFB: Outperform). Although risks, such as integration of TRW remain, we believe the current weakness in NOC shares should be an opportunity to build up positions. Firstly, this pure defence-play covers a wide range of segments (Electronics Systems, Integrated Systems, Information Technology, Ship Systems, Mission Systems, and Space Systems), which should protect earnings from a short fall. Secondly, we expect Bush to continue the war on terrorism, therefore increasing the defence budget. The president's FY2004 budget proposal represents $15bn of growth, or a 4.2% increase over the 2003 budget. Furthermore the Department of Defence's budget is expected to grow to $483.6bn in FY2009, which represents an annual growth rate of 4.9% p.a. on average (source: JP Morgan).

Finally, geopolitical tensions (Iraq and North Korea) should be a plus for an increase in defence spending. Apart from the current integration of TRW, some other issues could limit the upside potential of NOC stock price. Last week, NOC reduced its expected EPS from $4.00-$4.50 to $3.65-$4.15 due to a $100mn increase in interest expense guidance, but left its sales guidance unchanged, meaning that the current environment for defence contractors remains sound. However, this could have a negative effect on Street's opinion about NOC management, which underestimated the costs related to recent acquisitions. In our view, the main risk is an upturn in U.S. markets. On a two-year basis, the correlation between Northrop Grumman stock price and S&P500 is negative (-0.398, source: Bloomberg). Hence, if the U.S. markets would rise, investors would switch from defence industry to sectors with more volatility. At this time, we do not expect a sustainable upturn in U.S. markets; hence we believe NOC offers an attractive way to diversify portfolios.

The current stock market environment calls for high levels of caution. The imminent possibility of a military intervention in Iraq raises the uncertainty in the stock market. Crude oil prices, driven by supply concerns, continue to trade at high levels above USD 36 per barrel for the West Texas Intermediate, which closed at USD 37.78 last Friday, the 7th of March. These high oil prices build a solid fundamental base for the oil exploration and production industry, as new exploration projects promise a good profit opportunity. In fact the rig count, which indicates the number of rigs being used for exploration, has been rapidly rising since October 2002. The rig count in the United States has been in an upward trend since the start of this year.

This builds a strong case for the oil services industry, which operates in various areas of the exploration and production. It includes seismographic research, drilling activities, servicing, and is offered by companies like Noble Corp (NE, $36.35, CSFB: Neutral), and Schlumberger (SLB, $40.14, CSFB: Neutral), which are on our US Buy list.

Noble Corp should also benefit over the long term from its leading position in the deep-water offshore seismographic and drilling business as more of these areas are being explored for new oil reserves.

In general we expect this trend in the exploration growth to continue. The risks in the supply situation related to a military intervention in Iraq and also the historically low inventory levels are strong drivers to push integrated oil companies to raise their production. Companies like Exxon Mobil (XOM, $34.79, CSFB: Neutral), the integrated oil company we recommend as a BUY, have announced that they are boosting their spending in the exploration and production in order to capitalise on high oil prices.

The oil service stocks, and in particular Noble Corp and Schlumberger, two leaders in their respective areas of the industry, offer an attractive opportunity for trading oriented investors, to play the oil cycle.

Altria Group's (MO, $35.82, CSFB: Not Rated) share price plummeted nearly 4% on Friday's close due to the imminent ruling on a Class Action lawsuit brought against the company in the State of Illinois. The presiding judge indicated that come hell or high water he would be done with the case late afternoon (EST) Monday 10th March. Early indications and comments from the judge would suggest that his ruling could quite possibly go against Altria Group. The amount awarded, if the ruling goes against Altria, could be in the mid single digit billions. We are still strong believers in the stock for its safe and high dividend yield. Altria is well diversified in that only 28% of its operating income comes from US Tobacco with the rest emanating from its international tobacco business and Kraft. We would like to reiterate that this current case is in the context of what we strongly believe to be a legal risk profile in secular decline. We are still of the belief that the real problem is weak US Tobacco fundamentals and NOT sensational lawsuits. Given the well-diversified nature of Altria's portfolio of businesses we believe the company's food and international tobacco business should be able to shoulder the burden of weak US Tobacco fundamentals. The stock is currently yielding an attractive 7%. We will keep you posted on the outcome of the case.

Europe
• The DJ EUR Stoxx 50 closed the week 7% lower at EUR 1992.45 amidst rising geopolitical uncertainties and a strengthening Euro.
• The ECB's 25bps cut was disappointing and could not reverse the downward trend.
• We reiterate our focus on the following themes: dividend yield, energy and gaining of market share.

European markets took another plunge this week amidst rising uncertainties of developments in the Middle East and a rising Euro, which crossed the EUR 1.10 level on Friday.
The 25bps cut in interest rates by the ECB could not reverse the downward trend as markets anticipated a more significant cut of 50bps. Given the smaller than expected rate cut we expect the central bank to follow with further cuts in the near future. The Bank of England left rates unchanged as expected.
On the other hand, the Swiss National Bank surprised the market with its 50bps cut in its target rate to 0-0.5%.

We would like to point out one of the sectors, which is less affected by a weaker Dollar, which is the telecom sector and in particular we like Vodafone (VOD LN; GBP 1.085). Vodafone is also one of the companies we put in our presentation we published at the beginning of the week under the theme 'market share gainers'. As a result of the currently compelling consumer GPRS offer (Vodafone Live!), Vodafone is winning back share of adds in Europe after several quarters of decline. The costs of upgrading customers to GPRS are being partially offset by more 2G revenue whereas for the competition, the upgrade cycle threatens margins and market share.

CSFB upgraded the food producers & processor sector from underweight to overweight. Reasons for the upgrade are low valuation of an industry, which shows strong cash generation, predictability and one of the highest free cash flow yield in the market. Whereas concerns over higher raw material costs offset the defensive characteristics of the sector and influenced the sectors' lacklustre performance year to date, CSFB can't find any correlation between movements in raw material costs and movements in EBITDA margins nor any statistically significant relationship between soft commodity costs and sector performance.

Our favourite in this sector remains Nestle (NESN VX; CHF 245.25). Nestle came under pressure last week as it was asked by the US antitrust regulator to sell some of its luxury ice-cream brands and retail delivery systems before completing its takeover of US biggest ice cream maker Dreyer's Grand Ice Cream Inc. The ice cream business is one of Nestle's core strategic business due to its longer-term growth prospects. With the acquisition of Dreyer, Nestle's share would come to about 18% just slightly behind current market leader Unilever (UNA NA; EUR 49.78).

We expect the stock to remain under some further pressure until a final outcome of the discussion is reached. The stock is currently trading at a discount of over 40% to its 6.5-year average and given its strong and robust business and potential for margin and earnings growth we remain positive on the stock.

LVMH (MC FP; EUR 37.45) released FY 2002 results. Operating profit rose almost 29% to EUR 2.008bn, which is above the 25% increase the company mentioned earlier on and above market estimates. Net income came in slightly below expectations at EUR 556m and operating profit slightly above expectations at EUR 2.008bn. The group posted improvement in profitability across all brands except the watches and jewellery, which is in an investment phase. Record margins and an exceptional performance across all geographic markets but notably in Japan could be posted for the Louis Vuitton brand.

LVMH's strategy to close unprofitable duty-free stores after Sept 11 and to open a new megastore in Japan seems to bear fruits and the results show the resilience of the luxury goods maker despite the difficult environment. With a PER of 15x the valuation for the luxury goods sector is currently very favourable by long-term comparison.

Please also note European stock picks for our theme presentation, which we published at the beginning of the week:
1) Dividend Yield:
TotalFinaElf (FP FP; EUR 118.1)
ENI (ENI IM; EUR 12.974)
BNP Paribas (BNP FP; EUR 35.15)
Societe Generale (GLE FP; EUR 46.76)
Stora Enso (STERV FH; EUR 8.47)
DaimlerChrysler (DCX GY; EUR 26.26)
2) Energy:
TotalFinaElf (FP FP; EUR 118.1)
ENI (ENI IM; EUR 12.974)
3) Market share gains:
SAP (SAP GY; EUR 70.60)
Vodafone (VOD LN; EUR 108.50)