Aerospace And Defense Industry: Bullish Outlook

The aerospace and defense industry found its largest base in the U.S. with a military budget fittingly impressive. The country's global leadership position requires it to maintain the capacity to respond to the ever-changing national security environment.

In April 2013, the Obama administration proposed a defense budget of $526.6 billion for FY14, down $0.9 billion from the FY13 annualized continuing resolution level of $527.5 billion. However, the FY14 request does not yet include a detailed budget for Overseas Contingency Operations ("OCO"), which is essentially government-speak for foreign wars and war on terror operations. The government is yet to release the OCO budget.

The budget calls for the termination of a few programs which include C-17 Airlifter, F-22 stealth fighter, Future Combat Systems, Multiple Kill Vehicle, Kinetic Energy Interceptor, Airborne Laser, Combat search and rescue helicopter and Presidential helicopter.

Budget Issues - the Sequester

The budget sequester that went into effect at the start of March 2013 and that has a direct bearing on the U.S. government's defense spending is a function of the country's fiscal and economic challenges.

Per a media report released in June this year, the government has provided details of $37 billion of sequestration cuts to occur by Sep 30, 2013. These cuts will not spare any of the defense majors from Lockheed Martin Corp. (LMT) to Huntington Ingalls Industries Inc. (HII).

The Pentagon faces another $52 billion in reductions from planned spending for the next fiscal year, if Congress and President Barack Obama don’t reach a consensus on reducing the U.S. budget deficit.

Offsetting the Sequestration Effect

Sequestration will cut some $1 trillion from the defense budget over the next decade, according to The Washington Free Beacon. Yet, the aerospace and defense industry is holding up well this year thanks to technological innovations, big contracts, acquisitions and growing commercial demand.

Since the domestic aerospace and defense sector is facing budget cuts and a constrained spending environment, the industry is looking for growth from international orders. Additionally, a number of new emerging markets as well as developed nations, such as India, Japan, the United Arab Emirates, Saudi Arabia and Brazil, are boosting defense spending and generating business for the U.S. aerospace and defense companies.

Moreover, these defense behemoths have diversified their businesses to counter the effect of the sequester. Also, the complex military programs being awarded to these companies much before the across-the-board spending cuts came into force have somewhat diluted the sequester impact.

Zacks Rank

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 260+ industries is that the outlook for industries with Zacks Industry Rank of #88 and lower is 'Positive,' between #89 and #176 is 'Neutral' and #177 and higher is 'Negative.' Zacks Industry Rank for the Aerospace industry is at #69 out of 260 industries, which puts it in the Positive zone.

Please note that the Zacks Rank for stocks, which is at the core of our Industry Outlook, has an impressive track record going back years, verified by outside auditors, to foretell stock prices, particularly over the short term (1 to 3 months).

Five of the nine companies in our coverage has a Zacks Rank #2 (Buy). While 3 carry a Zacks Rank #3 (Hold), one holds a Zacks Rank #5 (Strong Sell).

European Aeronautic Defence and Space Company EADS N.V. (EADSY), General Dynamics Corp. (GD), Huntington Ingalls Industries, Lockheed Martin and Northrop Grumman Corp. (NOC) carry a Zacks Rank #2 (Buy). While The Boeing Company (BA), Erickson Air-Crane Incorporated (EAC) and Wesco Aircraft Holdings, Inc. (WAIR ) carry Zacks Rank #3 (Hold), Embraer SA (ERJ) carries a Zacks Rank #5 (Strong Sell).

Earnings Review and Outlook

The second-quarter earnings season has been a testament to the bullish trend in the defense sphere, defying sequestration and budget cut woes. The earnings results of all the defense companies in our universe except one surpassed the Zacks Consensus Estimate.

The highest positive surprise of 43 cents came from Lockheed Martin while the lowest surprise of 2 cents coming from Textron Inc. (TXT). Embraer SA missed the Zacks Consensus Estimate by 23%.

As per our data, as of Aug 1, 2013, the top and bottom line earnings beat ratio was 87.5% and 75%, respectively as compared to 49.9% and 66.7%, respectively, for S&P 500 companies.

For a detailed look at the earnings outlook for this sector and others, please read our weekly Earnings Trends reports.

The table below provides an outlook for the defense companies in our universe:

The Gainers

From Mar 1, 2013 to date, there have been a number of share price gainers with Alliant Techsystems Inc. (ATK) witnessing the highest increase of 55.80% while Textron gaining 1.16%.

Alliant Techsystems

Alliant Techsystems with a Zacks Rank #1 (Strong Buy) witnessed a positive earnings surprise of 16.67% this quarter and 15.68% over the last four quarters. Strong results reflect increased profits, lower interest expense, a lower tax rate and a decline in the share count.

The company uses its cash in the best possible manner. Recently, the company acquired Caliber Company, the parent company of Savage Sports Corporation. The acquisition gives the company an opportunity to bolster its leadership position in sporting and security ammunition and accessories into the long guns market.

Apart from the company’s cash deployment strategy, a continuous in-flow of contracts and an order backlog of $1.4 billion make it a Strong Buy.

Raytheon Company

Driven by operational improvements and capital deployment actions, the earnings surprise this quarter for Raytheon Company (RTN) was a positive 26.15%. Surprise over the last four quarters was a positive 22.15%. Beginning Mar 1, 2013, the company’s share price has risen approximately 43%. Raytheon sports a Zacks Rank #1 (Strong Buy).

Though the third quarter 2013 and full year 2013 estimates in the table above depict a year-over-year decline, Raytheon looks good with continuous in-flow of contracts, introduction of new products, completion of flight test series, consolidation and earnings beat to boot.

As of Jun 30, 2013, the company had a funded backlog of $22.2 billion that would convert into revenues in the near term. In addition, the strong cash position, consistent dividend payment and repurchase of shares make the stock look attractive. Indeed, the company’s strong cash position of $2.5 billion has been helping it to acquire other firms. In June this year, the company acquired Visual Analytics Inc. that will help the company in meeting the data analytics, data visualization and information sharing needs of its customers.

Northrop Grumman

From Mar 1, 2013 to date, the company’s share price has boosted 46.5%. It has delivered a positive earnings surprise of 20.59% this quarter driven by a lower share count and strong operating performance. The earnings beat over the last four quarters comes to 13.22%.

A steady flow of contracts which also include international orders, a funded backlog of $23.2 billion, introduction of new products, and the tendency of returning wealth to its shareholders drive this Zacks Rank #2 (Buy) stock.

Lockheed Martin

Lockheed Martin, the foremost defense prime, experienced its share price rise 42.2% since Mar 1, 2013. The positive surprise was 19.46% in this quarter and 15.44% in the last four quarters.

Lockheed Martin with a Zacks Rank #2 (Buy) has a strong liquidity position and utilizes the cash in the best possible manner via dividends and share repurchases. Loaded with contracts, Lockheed Martin is building three models of the F-35 for the U.S. military and eight international partner countries including Britain, Australia, Canada, Norway, Turkey, Italy, Denmark and the Netherlands. Israel and Japan have also ordered the jet. Lockheed Martin’s F-35 program accounts for approximately 15% of the company’s revenue, which is expected to go up in the coming years.

Huntington Ingalls Industries

This company carrying a Zacks Rank #2 (Buy) ended the quarter with a 21.74% positive surprise driven by solid program execution at Ingalls Shipbuilding and Newport News Shipbuilding while it posted a 7.71% positive surprise over the last four quarters on average. Beginning Mar 1, 2013, the company saw its share price soar 35.5%.

Good to Hold

The Boeing Company

Though the company carries a Zacks Rank #3 (Hold), we note that it has surpassed the Zacks Consensus Estimate by 5.70% in this quarter driven by solid operating performance fueled by higher aircraft deliveries and lower 787 Dreamliner production costs. Over the last four quarters, the company experienced a 12.87% positive surprise on an average.

Despite various technical issues at its Commercial Airplane Division, the company’s share price seems to be shock resistant, rising 38.70% from Mar 1, 2013. Backlog and deliveries are also robust. Total Defense, Space & Security backlog was $51.5 billion as of Jun 30, 2013.

Losers

Embraer SA

The company showed a negative earnings surprise of 23.08% this quarter reflecting lower commercial aviation deliveries. It experienced a 36.12% negative surprise over the last four quarters on an average. The company’s share price has also dipped 1.04% beginning Mar 1, 2013.

The company has a Zacks Rank #5 (Strong Sell) and is recommended to be avoided for the time being.

Pros and Cons

Undeterred by defense budget cuts, the big defense operators are expanding their operations through acquisitions. Moreover, in order to counter the domestic headwinds, these players are looking for growth from international orders and are busy restructuring their businesses. Also, they are keeping themselves abreast in the technological front with new products countering fresh competition.

The broad growth and development of the aerospace and defense industry is tied to the defense budgets of different nations around the globe, besides the U.S. The U.S. defense department has reduced the defense budget significantly. These cutbacks will impact the big contractors, as the lion's share of their revenues comes from domestic defense spending. Moreover, with the majority of revenue coming from government contracts, the industry could be adversely affected by the cancellation and delay of major government contracts. Again, with more and more acquisitions being made by the defense players, there is always the risk of completion, integration, and financing of these deals.

Our Take

The aerospace & defense industry has been a keystone of the U.S. economy for decades and has provided well paying jobs for a variety of skill levels. The U.S. aerospace industry continues to contribute significantly to the country's economy and provides capabilities vital for national security.

However, on the flip side, the industry's position is now challenged by global competition, changes in technology, national and worldwide economic conditions, and global policies affecting defense, civilian and commercial aviation.

Moreover, any delay in the execution of orders would lead to an imbalance between the cost and revenue structure. This would not only hurt profitability but also lead to delays and even cancellations of orders and/or programs.

Sequestration still remains an overhang both in the civil and military sectors. The companies that have little diversification outside the U.S. are highly susceptible to spending cuts from sequestration. On the other hand, those with an international order book would find it less difficult to outwit sequestration.

Keeping in mind the solid earnings season, technological progress, acquisition benefits and cost-cutting efforts of individual companies, we have an overall bullish outlook for the sector.

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