Aerospace & Defense Industry Outlook - November 2017

Widespread geo-political as well as socio-economic tensions have been boosting the growth of the aerospace and defense industry for decades. In recent times, escalating international terrorist attacks along with the emergence of civil wars like those in the Middle East have been adding more impetus to this space.

Moreover, a solid improvement in revenue prospects of this industry has been witnessed, in particular during last year, courtesy of President Trump’s actions taken in defense-related policies. Another factor driving this industry has been the rise in defense spending by other major regional powers such as Japan, China and India.

Impressively, stocks in the Zacks Aerospace sector (a stand-alone sector) have rallied +32% in in the last 12 months, significantly outperforming the S&P 500 index’s +18.6% gain. With a majority of macroeconomic factors favoring this industry, such outperformance can be expected to continue in the days ahead as well.

U.S. Defense Scenario

Given the size of its domestic market, the U.S. comprises by far, the largest market for defense equipment, systems, and services in the world.

Primarily, factors like growing international market for weaponries with more developing nations expanding their defense spending, the advent of innovative technologies in warfare and their increasing application as well as increased demand for cost-efficient production are driving revenue growth in the U.S. Aerospace and Defense industry.

Moreover, the ever-present North Korea situation as well as issues with Russia have prompted the administration to strengthen the country’s military capabilities, which means more orders for defense contractors and in turn more investment in this industry.

The sector is also benefiting from a stable domestic economic environment, with the U.S. economy achieving GDP growth in excess of +3% in each of the last two quarters. This has set the stage for more upside in the aerospace-defense industry, since a strong economy can better support defense funding. With the economy projected to come up with solid GDP growth in the fourth quarter as well, we may expect the industry to grow at an accelerated pace.

However, a decline in skilled workforce and increasing competition with emerging nations vigorously engaged in unveiling their own defense equipment continue to pose as challenges to this industry. Nevertheless, its non-cyclical feature has always helped the industry to overcome all the oddities and stay afloat.

Budget Updates

In September 2017, the U.S. Senate approved a $700 billion defense policy bill for 2018 that exceeded the nation’s statutory budget cap. The bill authorizes $640 billion for defense spending and $60 billion for Overseas Contingency Operations.

Earlier, on Mar 16, 2017, President Trump unveiled the Pentagon's fiscal 2018 (FY 2018) budget proposal, reflecting a total increase of $54 billion over the current FY 2017 level. The proposed budget of $639 billion includes a base budget of $574 billion, reflecting a $52 billion increase over the FY 2017 budget level of $587 billion. This budget also includes $65 billion in funding for the Pentagon’s overseas contingency operations (OCO) fund, higher than the FY 2017 level by $2 billion.

Such favorable budgetary allocations have been a big reason for the strong momentum in the sector’s stock market performance.

Zacks Industry Rank – Mixed Bag

The Zacks Industry Rank relies on the same estimate revisions methodology that drives the Zacks Rank for stocks. The way to look at the complete list of industries is that, we put our X industries (all 265 of them) into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank.)

The Aerospace is one of the 16 broad Zacks sectors within the Zacks Industry classification. Aerospace is further sub-divided into three industries at the expanded level: aerospace/defense, aerospace/defense equipment and electric-military.

Aerospace/defense, with a Zacks Industry Rank #103, as well as electronics-military with a Zacks Industry Rank #120, remain in the top half. Aerospace/defense equipment also with a Zacks Industry Rank #103 came in the top half.

Earnings Review and Outlook

Amid headwinds, the Aerospace sector held up well in the third quarter. The earnings beat ratio for 90% of the stocks in this space (percentage of companies coming up with positive surprises) was an impressive 77.8%, while the revenue beat ratio was 33.3%.

Going forward, the picture for the fourth quarter of 2017 is mixed. The sector’s earnings are expected to improve a solid 7.5% in the fourth quarter, while revenues are expected to see a 5.6% decline (as of Nov 8, 2017). Margins for this sector are expected to rise 7.8%. Notably, this sector is one out of the 13 of the 16 Zacks sectors that are expected to exhibit positive earnings growth this quarter.

Defense Stocks Worth Adding

Investors might keep a watch on the following defense biggies that have the financial strength to withstand headwinds and reflect an impressive earnings scorecard.

Huntington Ingalls Industries, Inc. (HII) has a long-term earnings growth projection of 15%. This stock registered positive earnings surprise of 17.63% in the prior quarter. Its 2017 earnings estimates moved up 3.5% in the last 60 days. The company currently sports a Zacks Rank #2 (Buy).

Leidos Holdings, Inc. (LDOS) has a long-term earnings growth projection of 10%. This stock registered positive earnings surprise of 18.75% in the prior quarter. Its 2017 earnings estimates moved up 4.2% in the last 60 days. Leidos Holdings currently sports a Zacks Rank #2. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Summing Up

With the U.S. being the largest supplier of the world’s most-advanced weaponries, emerging global security threats force allied nations to turn to it for defense aid as well as for buying state-of-the art ammunition. Naturally, the nation’s aerospace and defense industry has been a direct beneficiary of this demand.

Since there is no indication as to any improvement in the worldwide uncertainty, this industry will likely continue to excel in the days ahead as will its stocks.

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