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Industry Outlook

Overview

The word “sequestration” had an ominous ring for the defense industry in the year 2013. Nonetheless, the industry has emerged relatively unscathed thanks to fleet renewals at airlines worldwide with more fuel efficient aircraft, a growing international market for the F-35 Joint Strike Fighter and increasing application of unmanned aircraft in warfare today.

Undeterred by defense budget cuts, the big defense operators are expanding their operations through acquisitions and foreign orders. They are also busy restructuring their businesses and keeping themselves abreast of technology to counter 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. These have to some extent compensated for lower defense spending at home. The U.S. defense department has reduced the defense budget significantly. These cutbacks will continue to impact the big contractors, as the lion's share of their revenues still comes from domestic defense spending.

On the other hand, strong performance in the commercial aerospace sector is being driven by growing demand for passenger air travel worldwide and by accelerated replacement of obsolete aircraft with more fuel-efficient models.

Budget Update

In Mar 2014, the Obama administration proposed a base defense budget of $495.6 billion for FY15, which begins on October 1, down $0.4 billion from the enacted FY14 budget of $496.0 billion.

For Overseas Contingency Operations (OCO), which is essentially government-speak for foreign wars and war on terror operations, the FY15 budget has $79 billion in it. The amount is equivalent to the request for FY14. However, a formal budget for OCO is still negotiable with the Congress and will be proposed once a decision about the scope of the enduring U.S. presence in Afghanistan is decided.

Additionally, in the FY15 budget proposal, there is a new contingency fund: the Opportunity, Growth and Security Initiative. The defense department set a budget proposal of $26.4 billion for this fund, which could also be used for urgent military requirements as well as high-priority systems upgrades and technology insertion.

This initiative also comprises additional funding for Joint Strike Fighters and P-8 aircraft and more spending on the Army Blackhawk program. Funding for military construction and base sustainment is also expected to increase. Funding for this contingency initiative will be compensated by mandatory spending reductions and tax reforms.

Again, for FY14, the $1.1 trillion Omnibus spending measure President Obama signed into law was a big relief for the Pentagon. The bill provides Pentagon with nearly $93 billion to buy weapons and another $63 billion for research and development.

Offsetting the Sequestration Effect

The sequester that went into effect at the start of Mar 2013 will cut spending by a total of approximately $1.1 trillion over the 8-year period from 2013 to 2021.Yet, the aerospace and defense industry is holding up well in 2014 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 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, the defense majors have diversified their businesses to counter the effect of the sequester. Also, complex military programs already awarded to these companies much before the across-the-board spending cuts came into force have somewhat diluted the sequester impact.

Zacks Industry 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 259+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #88 and lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative. To learn more visit: About Zacks Industry Rank.

The aerospace industry is one of the 16 broad Zacks sectors within the Zacks Industry classification. 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.

Zacks Industry Rank for 'aerospace/defense is at #44 out of 259 industries, which puts it in a positive light. The ‘aerospace/defense equipment’ -- with a Zacks Industry Rank #87 also comes under the top 1/3rd. However, the ‘electric-military’ lies in the bottom one-third of all Zacks industries, with a Zacks Industry Rank #192.

Hence, the general outlook for the aerospace sector is on the whole positive. Investors should however be a little weary of the bearish electric-military sub-industry.

Earnings Review and Outlook

The aerospace & defense sector posted an impressive performance in 2013, braving issues like sequestration, budget cuts and cancellation of big-ticket programs. In fact, in the year-end quarter, all the defense companies in our universe, except one, surpassed the Zacks Consensus Estimate.

The highest positive surprise of 85 cents was clocked by Embraer S.A. (ERJ) while the lowest surprise of 0.6% came from General Dynamics Corp. (GD - Analyst Report). On the contrary, Wesco Aircraft Holdings, Inc. (WAIR - Snapshot Report) missed the Zacks Consensus Estimate by 6.9%.

The aerospace sector’s earnings are expected to decline 5.1% in the first quarter of 2014 compared with 20.0% growth in the last quarter. However, the sector will likely witness 1.0% top-line growth in the to-be-reported quarter as against a 0.1% fall in the prior quarter.

For 2014 on the whole, the sector is expected to register bottom-line growth of 4.5% which will further rise to 10.5% in 2015. The top line will likely see 0.9% and 1.5% growth in 2014 and 2015, respectively.

For a detailed look at the earnings outlook for this sector and others, please see our weekly Earnings Outlook.

OPPORTUNITIES

Although the threat from sequestration remains for periods beyond fiscal 2015 and casts a shadow of uncertainty on long-term funding, we would prefer Huntington Ingalls Industries Inc. (HII - Snapshot Report), a Zacks Rank #1 (Strong Buy) stock, posting strong financial results and surpassing our estimates by 34.7% on an average in the last 4 quarters. This upside was driven by higher revenues from surface combatants and the Legend-class NSS program.

Since the start of 2014, there have been a number of share price gainers with General Dynamics witnessing the highest increase of around 11.5% so far buoyed by consistent contract wins and a stable fourth quarter performance. It posted a 7.5% positive surprise over the last four quarters on an average.

With approximately $2.7 billion of free cash flow exiting 2013, General Dynamics’ solid financial position well cushions the dividend payout. At the end of the fourth quarter 2013, its cash and cash equivalents stood at $5.3 billion, reflecting an increase of almost 61.0% from year-end 2012.

This Zacks Rank #2 (Buy) company recently boosted its quarterly dividend by 10.7%, marking the 17th consecutive increase and bringing the annualized payout to $2.48 per share.

Among the defense top players, Northrop Grumman Corp. (NOC - Analyst Report) has delivered a year-to-date return of about 2.4%, outperforming the S&P return of negative 1.4%. With a market cap of $25.29 billion, the defense major has a one-year return of 61.8%, higher than the S&P 500 return of 14.3%.

This Zacks Rank #2 (Buy) company successfully beat the Zacks Consensus Estimate on both the top and the bottom line in the fourth quarter of 2013 and has a positive earnings surprise of about 3.1% on an average over the last 4 quarters. The earnings beat was attributable to a lower share count and strong operating performance.

In a nutshell, a steady flow of contracts, which also include substantial international orders, a funded backlog of $22.5 billion as of Dec 31, 2013, the introduction of new products, and the commitment to return wealth to its shareholders make this stock attractive.

The world's third largest commercial aircraft manufacturer, Embraer SA’s fourth-quarter earnings jumped 177.0% from the prior-year quarter and beat the Zacks Consensus Estimate by 70.8%. This Zacks Rank #2 (Buy) company’s stellar performance was backed by strong demand for its commercial and executive jets.

Embraer expects double-digit growth in the Defense & Security segment for 2014 due to the continuous progress in the military transport (KC-390) as well as the Border Monitoring system, Super Tucano LAS program and satellite programs.

Now, in the electric/military group, our preferred name will be Raytheon Company (RTN - Analyst Report). Driven by operational improvements and capital deployment actions, the earnings surprise last quarter for Raytheon was a positive 17.0%. Surprise over the last four quarters was a positive 19.7%.

Although budget sequestration has weighed upon defense contractors, Raytheon appears to have clinched high-value contracts during the fourth quarter. Orders were even stronger with a book-to-bill in the quarter of 1.28x.

Foreign military contracts continue to be the vital growth driver for Raytheon. International sales represented 27% of total revenues in 2013, up 3% year over year. International sales are expected to rise in the mid single digit, contributing 30% of projected 2014 sales.

Recently, this Zacks Rank #2 (Buy) defense prime boosted its annual dividend by 10.0%, marking the 10th consecutive annual increase. The company’s share price has risen approximately 9.3% so far this year.

Investors can also consider another name in this electric/military space -- L-3 Communications Holdings Inc. (LLL - Analyst Report). The share price of L-3 Communications has been rising ever since it reported strong fourth quarter 2013 results on Jan 30. This Zacks Rank #2 (Buy) stock has delivered an average positive earnings surprise of 4.8% over the past 4 quarters, keeping investors’ confidence intact. The consistently strong performance was due to L-3 Communications’ program execution capability, cost-cutting initiatives and contribution from its international and commercial businesses.

One may also capitalize on opportunities in a related business sector that of aerospace and defense equipment providers. Our top pick in this space is Astronics Corp. (ATRO). This company has set new records for revenue, bookings and backlog in the fourth quarter 2013 accompanied with three significant acquisitions in the second half of the year propelling growth opportunities for the future.

Again, the near-term prospects of Alliant Techsystems Inc. (ATK) look good. It has delivered a positive earnings surprise of 43.5% last quarter and 22.2% over the last four quarters. The company’s Sporting segment continues to play an important role in this out performance. In the third quarter of fiscal 2014, the segment recorded a considerable 78.2% year-over-year increase in sales. This upside was primarily driven by the acquisitions of Bushnell Group Holding Inc. and Caliber Company.

Other promising stocks in the U.S. aerospace and defense space with a Zacks Rank #2 (Buy) currently include AeroVironment, Inc. (AVAV), B/E Aerospace Inc. (BEAV), BAE Systems plc (BAESY), Curtiss-Wright Corp. (CW), HEICO Corp. (HEI - Snapshot Report) and TransDigm Group Inc. (TDG - Analyst Report).

Good to Hold

Lockheed Martin Corp.
(LMT), the foremost defense prime, experienced its share price rise 8.9% in the year-to-date period. The stock holds a Zacks Rank #3 (Hold).

Although the threat of sequestration still lurks over this defense major, negatively impacting the company’s 2013 sales, Lockheed Martin seems to be on a wining spree in recent times. The defense premier generated $15.4 billion in orders in the fourth quarter of 2013. Again, the healthy dividend yield and stable cash flow will likely make the stock a defensive holding in the current market scenario.

Lockheed Martin’s pricey F-35 program is expected to gain significant traction in 2014 and 2015. Although the 2015 DoD request for procurement of $90.4 billion is down from the 2014 request of $115.1 billion, it comprises $4.6 billion for 26 F-35 Joint Strike Fighters for 2015, and $31.7 billion for 238 additional Joint Strike Fighters over the next several years. This will definitely trigger significant top-line generation for the company.

Another aerospace giant The Boeing Co. (BA), carrying a Zacks Rank #3 (Hold), has surpassed the Zacks Consensus Estimate by 18.2% in the past quarter driven by solid operating performance fueled by higher aircraft deliveries. Over the last four quarters, the company experienced a 14.6% positive surprise on an average.

Backlog and deliveries are also robust. Total Defense, Space & Security backlog was $67 billion as of Dec 31, 2013.

The aviation and military electronics maker Rockwell Collins Inc. (COL), posted strong fiscal first quarter 2014 results backed by solid contribution from its Commercial Systems and Government Systems segments. The company delivered a positive earnings surprise in three out of the last four quarters, with an average beat of 0.99%, showing a somewhat stable operational performance.

WEAKNESSES

We remain apprehensive on the Zacks Ranked #5 (Strong Sell) company AAR Corp. (AIR). This aerospace and defense products and services supplier continues to face continued pressure in airlift and MRO services. As a pointer, the company has lowered its top- and bottom-line forecast for fiscal 2014.

Other Zacks Ranked #4 (Sell) stocks like Kratos Defense & Security Solutions, Inc. (KTOS - Snapshot Report), Rolls Royce Holdings plc (RYCEY) and Triumph Group, Inc. (TGI - Analyst Report) are also to be avoided.

We are also skeptical of these Zacks Ranked #5 (Strong Sell) stocks – Leidos Holdings, Inc. (LDOS - Snapshot Report), CPI Aerostructures Inc. (CVU), API Technologies Corp. (ATNY), and FLIR Systems, Inc. (FLIR).

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.

On the whole, budget austerities still remain an overhang on the military sector. 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.

Admittedly, the sector enjoyed a solid earnings season, technological progress, acquisition benefits and cost-cutting efforts from individual companies. This keeps us generally positive on the sector for the time being.

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