Tariff Hurts Aerospace-Defense Stocks, Passenger Growth Aids

The Zacks Aerospace-Defense industry comprises companies that primarily design and manufacture heavy-built products like commercial as well as military jets and helicopters, tankers and other combat vehicles, missiles, combatant ships as well as auxiliary ships, submarines, bombs, guns, space transportation vehicles, military satellites and a few more.

The industry also includes cyber security players who offer information technology (IT) services and C4ISR (command, control, communications, computers, intelligence, surveillance and reconnaissance) solutions.

A portion of revenues comes from defense contractors, offering spare parts, aircraft modification, ship repair and overhaul services and supply chain management services. Some of the prominent stocks in this industry are Huntington Ingalls Industries (HII), L3Harris Technologies (LHX), Northrop Grumman (NOC), Boeing (BA) and Textron (TXT).

Here are the three major industry themes:

• A steady improvement in global air traffic has pushed up commercial airplane demand, thereby providing an impetus to the U.S. Aerospace and Defense industry. Per the latest forecast made by the International Air Transport Association (IATA) in December 2019, global air passenger numbers are expected to rise 4% to 4.7 billion in 2020 from 4.5 billion in 2019. Meanwhile, Boeing, the largest jet maker, expects that the world will need 44,040 new planes, worth $6.8 trillion, over the next 20 years. The new outlook indicates 6.7% improvement from the company’s previous 20-year outlook. The improved projection is based on strong air-traffic trends in the emerging markets of Asia-Pacific, along with established markets of Europe and North America. Increasing jet demand is expected to drive the aviation services market. To this end, Boeing expects commercial aviation services market to grow 4.2% annually, thereby reaching a value of $9.1 trillion by 2038. Thus, the short as well as long-term growth prospects of U.S. aerospace-defense stocks seem bright.
  
• With the United States being the largest supplier of defense products, it is undoubtedly a golden era for the nation’s aerospace and defense stocks. U.S. defense majors are expanding their foreign markets rapidly, particularly taking advantage of regional tensions prevailing in the Middle East lately. According to the latest report from Aerospace Industries Association (AIA), the U.S. Aerospace and Defense industry generated $151 billion in exports, up 5.8% year over year, and a solid trade surplus of $89.5 billion in 2018. Notably, the industry is currently the nation’s leading net exporting industry. With no indication of the global geopolitical unrest coming to an end anytime soon and nations like Japan and India raising their defense budgets significantly, the winning streak for these stocks is expected to continue in the near term.
  
• In January 2020, the Trump administration announced plans to expand its existing tariffs on imports of steel and aluminum, stating that from Feb 8, steel and aluminum derivatives will also come under the tariff mandate. Now this tariff expansion is expected to deal a heavy blow to the U.S. aerospace and defense industry, which relies heavily on imported aluminum. In 2018, when the initial tariff was imposed, the AIA had expressed concern by saying that such a tariff will raise cost and disrupt the supply chain. Now that tariffs are being imposed on derivatives as well, the growth prospects for defense stocks seem bleak.

Zacks Industry Rank Indicates Dismal Prospects

The Zacks Aerospace-Defense industry is housed within the broader Zacks Aerospace sector. It currently carries a Zacks Industry Rank #179, which places it in the bottom 30% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates dull near-term prospects. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

The industry’s position in the bottom 50% of the Zacks-ranked industries is due to a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts have lost confidence in this group’s earnings growth potential over the past few months. Evidently, the industry’s earnings estimates for the current fiscal year have gone down 31% to $10.06 since October 2019.

Before we present a few aerospace-defense equipment stocks that you may want to add to your portfolio, let’s take a look at the industry’s recent stock market performance and valuation picture.

Industry Lags S&P 500& Sector

The Aerospace-Defense industry has underperformed the Zacks S&P 500 composite but underperformed its own sector over the past year. The stocks in this industry have collectively gained7%, while the Aerospace sector has rallied 12.5%. The Zacks S&P 500 composite has risen 20.3% in the said timeframe.

One-Year Price Performance

Industry’s Current Valuation

On the basis of trailing 12-month EV/Sales ratio, which is used for valuing capital intensive stocks like aerospace-defense, the industry is currently trading at 1.88, compared with the S&P 500’s 3.06 and the sector’s 1.79.

Over the past five years, the industry has traded as high as 1.96X, as low as 0.96X, and at the median of 1.38X, as the charts show below.

EV-SALES Ratio (TTM)

Bottom Line

Latest budget proposals from Pentagon reflect hawkish spending provisions for the U.S. Department of Defense. These along with impressive growth trends projected for the global air passenger growth are expected to drive the U.S. aerospace and defense industry in the near term. However, rising tariffs on inputs may push up cost of production for this industry, thereby hurting its bottom line.

Nevertheless, considering the fact that the aerospace and defense industry isone of the biggest manufacturing sectors in the United States, investors may bet on a few stocks in this space that exhibit a strong earnings outlook.

We are presenting three aerospace-defense stocks with a Zacks Rank #2 (Buy) or #3 (Hold) that investors may want to keep in their watchlist. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Leidos Holdings, Inc. (LDOS): For this Reston, VA-based company, the Zacks Consensus Estimate for 2020 EPS indicates year-over-year improvement of 14.2%. This Zacks Rank #2 stock came up with average positive earnings surprise of 8.93% in the trailing four quarters.

General Dynamics (GD): For this Falls Church, VA-based company, the Zacks Consensus Estimate for 2020 EPS indicates year-over-year improvement of 6.8%. This Zacks Rank #2 stock came up with average positive earnings surprise of 3.75% in the trailing four quarters.

Lockheed Martin (LMT): For this Bethesda, MD-based company, the Zacks Consensus Estimate for 2020 EPS indicates year-over-year improvement of 10.1%. This Zacks Rank #3 stock came up with average positive earnings surprise of 15.91% in the trailing four quarters.

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