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Frustration may be spreading on many fronts in the war on terror. For now, however, investors in defence contractors have not shared the pain. Over the past 12 months, returns in US aerospace and defence shares have beaten the broader market by 10 percentage points. Lockheed Martin, the world’s largest defence contractor, has done even better, with returns of 45 per cent, almost three times those of the S&P 500.

Lockheed’s latest results – along with those of Northrop Grumman, best known for its warships – provide some ammunition for defence enthusiasts but also suggest a need for caution. Even after stripping out one-off gains, Lockheed once again beat earnings expectations in the third quarter. That is all the more impressive given that analysts’ forecasts have been steadily rising. However, revenues were up just 6.7 per cent at Lockheed and were even weaker at Northrop.

At least both benefited from rising operating margins. Changes in product mix were partly responsible for this, with Lockheed’s recent focus on IT in particular starting to pay off. Mainly, however, defence contractors seem to be getting better at squeezing higher profits out of a slow-growing sales base.

Operating leverage, however, can be a bit of a double-edged sword when the bulk of revenues are dependent on a single customer. At Lockheed, about 85 per cent of 2005 sales were to the US government, with another 13 per cent to foreign governments (including those funded by the US). But growth in overall US defence spending is likely to slow and calls for more boots on the ground instead of high-tech gear are on the rise. Add the prospect of a Democratic victory in the mid-term elections and pressures on the Pentagon and other federal agencies to get a bigger bang for their buck are set to increase.

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