Analysis:U.S. defense stocks squeezed as challenges grow clearer

WASHINGTON (Reuters) - U.S. defense stocks faced headwinds on Tuesday as Lockheed Martin Corp (LMT.N) cut its 2010 full-year earnings forecast and Britain unveiled sweeping defense cuts that brought the myriad challenges facing weapons makers into clearer focus for investors.

Analysts have been predicting tougher times for U.S. defense companies for some time, given mounting budgetary pressures in Europe and the United States, and rising pension expenses linked to declining interest rates.

That means U.S. defense firms are looking to the Middle East and Asia for continued weapons sales in coming years, including an arms sale package with Saudi Arabia valued at up to $60 billion that could be formally announced this week.

That deal could help offset the bad news from Britain this week, said Teal Group analyst Richard Aboulafia.

He said Britain's cuts to its planned F-35 Joint Strike Fighter purchases were unlikely to have a material impact on the Lockheed program, the biggest arms program in the world.

NOTHING NEW, BUT NOT GOOD

"These issues aren't new, but it's the scale and the immediacy of these issues. It's a combination of factors," said defense analyst Rob Stallard with RBC Capital Markets, when asked to explain the overall market weakness on Tuesday.

He said Lockheed's frank and realistic assessment of its earnings forecast, pension costs and tightening profit margins made investors realize that other companies in the sector would likely face similar issues.

"It's not like these things are going to go away," he said, although he said most stocks in the sector were clearly resisting further downturns, with some investors ready to buy shares at current lower prices.

The S&P Aerospace & Defense Index .GSPAERO closed 1.63 percent lower on Tuesday, outpacing the Dow Jones Industrial average .DJI, which was off by 1.48 percent.

Loren Thompson, a defense analyst with the Virginia-based Lexington Institute, said a downturn in defense was already priced into U.S. stocks, but Britain's announcement was clearly seen as a negative signal.

"As we get this drip, drip, drip of bad news from places like Britain, that will undoubtedly have a depressing effect on share prices going forward," he said.

Lockheed on Tuesday posted a lower quarterly profit and said contract delays and cancellations in the tough environment for global defense spending could hold down 2011 results.

Lockheed shares were down as much as 3 percent, but later recovered and closed 0.81 percent lower at $69.47.

Lockheed said it was pleased that Britain had reaffirmed its commitment to the F-35 Joint Strike Fighter program, and would work closely with Britain to assess the impact of any cuts in its planned F-35 purchases and a decision to shift away from the short takeoff and landing version of the F-35.

"We're confronting a new reality where increasingly complex global security issues and increasingly constrained resources are putting enormous pressure on our customers to meet the challenges they face," said company spokeswoman Nettie Johnson.

BOOST FROM SAUDI DEAL

Boeing Co (BA.N), which is due to report earnings on Wednesday, closed 1.68 percent lower at $69.05, but the stock could get a substantial lift from a multibillion dollar U.S. arms sales to Saudi Arabia, which the Pentagon is expected to formally notify lawmakers about this week.

United Technologies Corp (UTX.N), whose Sikorsky Aircraft unit is expected to see some helicopter sales to Saudi Arabia, could also benefit from the arms deal news, said Aboulafia.

"This is the biggest single purchase of export combat aircraft in decades," he said.

United Technologies shares closed 1.27 percent lower at $73.61.

Jay Korman, industry analyst with the Avascent Group, said news about the UK defense cuts confirmed what investors had been expecting for some time and underscored the budget problems faced by many of the United States' closest allies.

He said the Saudi arms sale would help offset the negative impact on several U.S. firms, but noted that competition for future international weapons deals would be intense.

(Reporting by Andrea Shalal-Esa in Washington with added reporting by Karen Jacobs in Atlanta; Editing by Phil Berlowitz)