Wall Street Transcript Interview with Kenneth Herbert, Senior Vice President of Equity Research at Wedbush Securities: Cybersecurity, Unmanned Systems Offer Opportunities as Defense Faces Budget Uncertainty

Wall Street Transcript

67 WALL STREET, New York - November 13, 2012 - The Wall Street Transcript has just published its Industrial Equipment, Aerospace and Defense Report offering a timely review of the sector to serious investors and industry executives. This special feature contains expert industry commentary through in-depth interviews with public company CEOs, Equity Analysts and Money Managers. The full issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

Topics covered: Commercial Aviation and Energy Expenditures - Industrial Restructuring - Emerging Markets Penetration - Heightened M&A Activity - Future Growth and Market Share Gains - Increased Commercial Aircraft Production Rate - Defense Budget Uncertainty - Growth Opportunities in Data Security -

Companies include: Boeing Co. (BA), Precision Castparts Corp. (PCP), Rockwell Collins Inc. (COL), TransDigm Group Incorporated (TDG), Triumph Group Inc. (TGI), Spirit AeroSystems Holdings In (SPR), Hexcel Corp. (HXL), Esterline Technologies Corp. (ESL), LMI Aerospace Inc. (LMIA), Curtiss-Wright Corp. (CW), Lockheed Martin Corporation (LMT), Northrop Grumman Corporation (NOC), Raytheon Co. (RTN), General Dynamics Corp. (GD), BE Aerospace Inc. (BEAV) and many others.

In the following excerpt from the Industrial Equipment, Aerospace and Defense Report, an expert analyst from Wedbush Securities discusses the outlook for the sector for investors:

TWST: Please give us a quick idea of what you are covering in this space. It's a rather large and disjointed area.

Mr. Herbert: I tend to focus on companies with more commercial aerospace exposure, but most of the companies that I cover do have defense and business jet and broader exposure. A few of the companies I cover include Boeing (BA), Precision Castparts (PCP), Rockwell Collins (COL), TransDigm (TDG), Triumph Group (TGI), Spirit AeroSystems (SPR), Hexcel (HXL), Esterline (ESL), LMIA (LMIA), Curtiss-Wright (CW) and a few others.

TWST: So it's kind of a broad spectrum then.

Mr. Herbert: Exactly.

TWST: Please start from the top down. We keep hearing about the upcoming sequestration and the effects it's going to have. What does this mean if it happens in January as it's scheduled?

Mr. Herbert: That means a fairly significant impact. I think a lot of companies would generally agree that they are looking at probably a 5% to 10% reduction relative to current expectations for their military business, if you do. In fact, have a situation where sequestration takes place. So certainly it would be a near-term as well as a long-term impact.

Keep in mind, however, we are operating under a six-month continuing resolution now, which is limiting spending options. More importantly, however, the risk of sequestration has taken on a larger impact due to complete uncertainty that it has injected into the markets and investors' outlooks.

TWST: In general, what are the companies focusing on?

Mr. Herbert: I would say the companies are focused in a few areas. First, sequestration is currently the law of the land, so companies are working to ensure investors that they are planning accordingly. Having said this, I would argue that companies are limited in what they can plan for due to the uncertainty as to exactly how it would be implemented.

Moreover, it must be mentioned that even the Department of Defense, DoD, has been vague in their guidance on how companies and markets should be thinking about the risk of sequestration, partly operating under the assumption that it would be such a negative scenario, there is no way that it could actually happen.

TWST: So stay tuned.

Mr. Herbert: Exactly.

TWST: I guess that's about all we can do at this point.

Mr. Herbert: Exactly. Certainly companies are planning for it. I think to your question, they are looking at what does a 5% to 10% reduction mean, and how do we react in terms of programs, in terms of headcount, in terms of everything else. So you are hearing certainly that some companies are starting to think about what do we do if it happens and how do we implement this. But they are certainly looking very much to their customer, the DoD, for guidance, and unfortunately, the DoD is not able to say a lot more right now than what they have already said, which isn't a significant amount.

TWST: Because they don't know either.

Mr. Herbert: No. It's hard to model in this situation, and I think everybody is cautiously optimistic it doesn't happen, but this is the law as it stands right now. We are optimistic that even with a divided government after the election, President Obama and the Congress will be able to find a solution to avoid the full impact of the fiscal cliff.

TWST: But as you said earlier, it's a rationale for people to stay away from the space.

Mr. Herbert: Yes, it would be fair to say that a rational investor should be staying away from this space. However, I would make a few points. Defense companies like Lockheed Martin (LMT), Northrop Grumman (NOC) and Raytheon (RTN) have successfully deployed their relatively strong cash flows to increase share repurchases and dividends, which have made these attractive yields.

Second, most firms with defense exposure have aggressively started to reduce their cost structure, which has also helped earnings hold up. As a result of the cost cutting and returning cash to shareholders, many defense stocks have performed relatively well, especially considering the headline risk we have just been discussing.

And finally, there is significant growth in commercial aerospace markets, which for many companies is offsetting weakness in their defense markets. We are about two years into a four- to five-year production ramp in commercial transport aircraft markets, which has provided a nice tailwind for firms with exposure primarily to Boeing and Airbus (EAD.PA).

TWST: What is the longer-term outlook for defense?

For more of this interview and many others visit the Wall Street Transcript - a unique service for investors and industry researchers - providing fresh commentary and insight through verbatim interviews with CEOs, portfolio managers and research analysts. This special issue is available by calling (212) 952-7433 or via The Wall Street Transcript Online.

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