Performances of companies in the aerospace and defence sector - mixed for some time to come (page 1 of 3)

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.