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Northrop-Grumman Faces Off With Budget Cuts

It's a tough time to be in the defense industry. With mounting cuts at the Department of Defense growing and sequestration up for a vote again soon, the sector's biggest players have had to cope with a business under attack. Defense giant Northrop-Grumman (NYSE: NOC  ) has felt the heat lately, as the company's shares have fallen more than 2.7% to start a lackluster year. In order to learn what's ahead for the company, let's take a look Northrop's quarterly earnings that were announced yesterday.

Beating the Street
Northrop did manage to beat analyst projections on earnings, despite total profit falling 2.7% year over year for the fourth quarter. The company recorded earnings per share of $2.14, a full $0.05 higher than last year's fourth-quarter figure. Analysts had projected adjusted EPS of just $1.74, but even when one-time items were excluded from the figure, Northrop still managed to pull in $2.06 to smash Wall Street's meager expectations.

Overall profit fell from $548 million to $533 million for the quarter, but a 5% reduction in outstanding shares helped the EPS figure shine.

Even as revenues sank 0.5% to $6.48 billion, Northrop still managed to top weak Wall Street projections of only $6.33 billion. The company's performance helped operating margins grow from 12.3% to 12.7% for the quarter, a strong sign that Northrop's making more out of less in this time of tightening defense budgets.

Unfortunately, some of the company's divisions aren't pulling their weight. The company's smallest division, technical services, saw sales retreat by 7%, while electronics systems and information systems slid by 5% and 2%, respectively. Northrop's going to have to either turn around its less-successful business in the future – or find a way to stem the tide of losses, even as its aerospace division continues to record revenue gains.

A tricky road ahead
Northrop's aerospace business, its largest segment, did manage to post sales gains of 7%, bringing in revenue of $2.6 billion. While that's good, the DoD's ongoing budget cuts will almost certainly slam high-priced purchases such as aircraft in the future.

While that's more damaging to competitors such as Lockheed-Martin (NYSE: LMT  ) and its costly, budget-overrun-plagued F-35 program (particularly with the DoD's frequent criticism of the company's handling of the project), Northrop will feel a hit in the future as well. Any cuts to the F-35 program itself could come back to hurt the company, as the company manufactures technology for the aircraft.

Competitors have already come out with pessimistic guidance figures for 2013. Raytheon (NYSE: RTN  ) forecasted adjusted earnings falling by as much as 9% in 2013, citing the possibility of further budget cuts in an already strict budgetary environment. General Dynamics (NYSE: GD  ) followed suit, recording fiscal year 2013 EPS guidance that fell between $0.60 and $0.70 short of what analysts expected. Northrop's own 2013 guidance projects continued falling sales, with the company estimating full-year 2013 revenues of $24 billion. That's already a decline of more than $1 billion from full-year 2012 sales of $25.2 billion, itself a decline from 2011.

Interestingly – and troublingly – many defense companies (Northrop included) are choosing to ignore the possibility of sequestration and further budget cuts in 2013 when making guidance. While that's fine for now, after Congress punted sequestration down the road a few months, any serious new round of budgetary slashing could come back to haunt defense companies. Northrop's in a particularly tough spot, given that company CEO Wes Bush announced that international sales would likely climb to 10% of total revenues over 2013. That's an improvement over the 8% of total sales in 2012, but it's still an incredibly vulnerable statistic should the government take an axe to the defense budget.

Considering U.S. Deputy Defense Secretary Ashton Carter said earlier that such further cuts are "more likely than unlikely," defense sector investors need to hold on for what could be a wild ride.

Tough times in the defense industry
Overall, virtually every player in the defense industry will face the wrath of budget cuts. Northrop's goal of increasing international sales should help to reduce that risk somewhat, but the company's still extremely centered on American sales. Investors should be happy with the company's latest earnings report, particularly as the company's managed to continue improving operating margins while revenues have fallen, but tougher times are closing in. Every defense investor needs to keep their eyes fixed on sequestration: If Congress pushes for more budget cuts, Northrop and its competitors could take a beating.

Defense companies have done well over the past few years, but 2013 brings a whole new batch of risks. There are still good companies galore in this sector, but was any defense stock good enough to be the new year's top pick? Find out which stock the Fool ranked No. 1 in our brand-new free report: "The Motley Fool's Top Stock for 2013." I invite you to take a copy, free for a limited time. Just click here to access the report and find out the name of this under-the-radar company.

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