This is not the time to be loading up on defense stocks. The department of defense's fiscal year 2012 budget request will be submitted in February and the discussions leading up to it will pressure the defense stocks. Also, given a shrinking backlog for many of the companies within the sector, I believe that consensus estimates remain meaningfully too high and will be revised downward throughout the 2nd half of 2010, particularly if current pension assumptions (i.e., interest rates and asset returns) hold.

Northrop Grumman Corp. (NOC) on July 28th, Northrop reported adjusted 2nd quarter EPS ahead of consensus, and revised guidance higher --- highlighting improved margin performance. However, cash flow was weak and Northrop joined the list of defense companies to report declining backlog and weak bookings. Here are my concerns regarding Northrop and why it is a stock to sell: 1) the company is way too leveraged to the defense sector view where I expect pressure on Department of Defense spending and contractor margins. Northrop also joined the list of defense companies reporting weak book-to-bill on the back of another sequential decline in backlog. 2) While Northrop showed some margin improvement in the 2nd quarter --- outside of ships --- its margins and returns on capital remain the lowest in its peer group. 3) If interest rates and asset returns simply stay where they are today, 2011 and 2012 estimates could be reduced down by 11% (of current EPS) or even more.

Readers of this space know that the preference is for long-term plays with companies with demonstrated business models (10 years), in an established market, with an average total annual return on equity of 20% during that span. It also helps if the company has a secular tailwind and/or is one of only a few players in a sector.

On the last point, Northrop Grumman Corp. (NYSE: NOC) ranks very high, and it fares reasonably well in the other categories, too.

Northrop is the U.S.'s No. 3 defense contractor and the No. 1 shipbuilder in the world. Analysts like NOC's operational diversity, cash flow, and solid balance, but the company's standout dimensions, from an investment standpoint, are its electronics systems business (21% of revenue) and its ship building business (17% of revenue).

The electronics business is likely to remain a key player in radar/navigation/communications systems, moving forward, and the ships business is also in a preferred position: it's one of only two nuclear-power submarine makers in the U.S. and the only builder of U.S. aircraft carriers. Of course, no one can predict with any certainty the role aircraft carriers will play in defense operations -- the aircraft carrier's demise has been predicted for (seemingly) the past three decades -- but the sense here is that these ships will retain a role in the decades ahead. The company also builds the B-2 stealth bomber and has a 25% stake in the F-35 next-generation, joint-strike fighter.

Boosted by a net income increase of 47%, the nation's top defense contractor, Lockheed Martin Corp. (NYSE: LMT), is looking for a strong start to the day. Currently, in the premarket, traders have pushed the stock up 3.0% after this morning's release.

Wall Street was looking for the company to come in with $1.24 a share in earnings, but LMT shattered that estimate with a reported $1.46. In addition, full year 2006 estimates are now being lifted to $5.45 to $5.60 a share from $5.10 to $5.30. Consensus estimates on 2006 earnings is currently sitting at $5.29.

The question is how will this carry into the trading day? Net income may have beat expectations, but sales did not. The company was expected to report $9.83 billion in sales, but came in at only $9.61. While this was still a nice 4% jump, we will have to see how the market takes that once the stock is being actively traded on the open market following the opening bell.

Much of the recent jump in income comes from the company being able to make advances in the production of the F-35 fighter plane, their next generation multi military branch combat jet. The company's most popular and well known jet, the F-16 fighter, saw sales fall last quarter. This partly led to the company missing its sales target as the aeronautics division reported a decline in sales of 7%. Luckily for LMT, this drop was counter-balanced by a 10% rise in sales from their systems and information-technology group, which is their largest division.

All in all, a pretty positive release, but how investors will reward the company for beating earnings estimates while missing sales remains to be seen.