Aerospace & Defense Sector Faces Consolidation Pressure

The aerospace and defense sector has been booming since the start of the year with returns north of 21%, close to doubling the S&P 500’s returns so far in 2019. The industry is at a crux position that could send these stocks one way or the other. Is it time to buy or stay away?

Aerospace and defense spending under the U.S. Pentagon is expected to slow over the next 5 years, according to analysts. The number of companies in this industry has declined substantially as the number of deals the U.S. government hands out has been tapered. Over 17,000 firms have exited the industry since the beginning of the 2000s with the U.S. Department of Defense deciding to narrow its focus and use a less diverse set of defense products.

The U.S. has by far the largest defense budget in the world with a plan to spend nearly $700 billion in 2019. The largest contractors include Lockheed Martin (NYSE:LMT) , Boeing (NYSE:BA) , and Raytheon (NYSE:RTN) . Lockheed Martin is the leading U.S. contractor with the majority of its revenues being derived from its F-35 jet fighter, which has replaced a dozen planes over the last decade, according to the WSJ.

This upcoming election could have a material effect on those stocks that rely heavily on government contracts for topline growth. Keep an eye on presidential polls and their defense stance.

Consolidation

The aerospace and defense industry has seen ramped consolidation in recent years as scale becomes increasingly important to compete in a industry that demands cost-cutting. The largest defense and aerospace merger ever was just announced between United Technologies (NYSE:UTX) and Raytheon. I discuss this merger in more detail in my article United Technologies + Raytheon: Becoming the #2 Player in Aerospace & Defense.

This merger was announced Sunday and has the entire industry on its toes. There is a considerable amount of uncertainty for what this colossal merger will mean for the rest of the sector. All of the major players are down today. This merger could lead to more consolidation in the industry as big players feel the pressure to scale.

Boeing (NYSE:BA)

Boeing has made 4 acquisitions over the past 2 years with companies from flight control applications to firms that design unmanned aircraft. Over the past 24 months, BA has more than doubled the performance of every possible benchmark, showing investors returns over 91%. BA is trading at a forward P/E of 20.2x, below its high of 30x in early 2018 but still above both its 5-year median and the sector. Boeing is the industry leader, and I would expect the firm to be trading at a higher multiple than its competitors based on the control that is associated with being an industry frontrunner.

Boeing is still recovering from the notorious 737 MAX crashes, with the most recent happening this past March. These crashes have had a devastating effect on the stock and it is yet to recover. The 737 MAX is grounded for an indefinite amount of time and will continue to weigh on BA until the issues are resolved. BA is currently trading 20% off of its high in March.

Lockheed Martin (NYSE:LMT)

Lockheed Martin has been performing exceptionally well since the beginning of the year, displaying over 33% returns to investors, more than doubling the S&P 500. The firm has shown exceedingly consistent top and bottom line growth over the past three years. LMT analysts have been upwardly adjusting their expectations for the company over the next 3 years, pushing LMT into a Zacks Rank #2 (Buy).

Lockheed Martin is trading at superbly low multiples for the growth that this firm has seen. LMT is being valued at a forward P/E of 15.7x, below the industry's 16.9x and far below its high of 25.4x last year. I would say LMT is a sound buy for this industry, especially when you consider the cushy 2.5% dividend that it hands investors annually.

Take Away

The aerospace and defense industry is considered to be relatively counter-cyclical. These stocks don’t collapse like the rest of the market when the economy hits rough patches because of the contract agreements these firms rely on. They do have quite a bit of political risk when these contracts are primarily government-owned, and like I mentioned, this upcoming election increases that risk.

The aerospace and defense sector as a whole is being valued at a forward P/E of 16.9x, off of their highs in late 2017/early 2018, with Trumps 2018 defense bill likely being the key catalyst. These stocks have calmed a bit over the past 18 months and are trading in line with the S&P 500. As a whole the political risk is too high for me to put on a large position in this industry. LMT is an expectation, based off of its reasonable multiples, positive EPS adjustments, and cushy dividend, if I were to invest in aerospace and defense I would undoubtedly buy LMT.

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