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Should We Worry About the Prospects of the Defense Industry?

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The Aerospace & Defense industry has remained mostly stable amid economic downturns, thanks to its non-cyclical nature. On top of that, the rise in global geopolitical uncertainty should bring good fortune to it. Yet we cannot overlook a number of issues that have been weighing on this space over the last few years.

Consistent budget cuts on part of the U.S. Department of Defense (DoD) amid the end of the wars in Iraq and Afghanistan caused the U.S. aerospace and defense industry to perform poorly in the past three years. The recent victory of Donald Trump has led many to believe that good times are back for the group based on his campaign pledge to spend heavily on defense.

These expectations have helped push defense stocks higher since Election Day, with many currently trading close to 52-week highs. With the incoming administration’s policy platform far from clear at this stage, many of these stocks will likely need to take a breather for reality to catch up with sentiment.

Various regulations imposed on international trade of defense equipment is another significant barrier to this sector’s growth. Moreover, "disproportionate" cuts to modernization and research and development funding could act as major impediments to defense players.

Below we discuss the headwinds that could weigh on the aerospace and defense sector in the near term.

Market Pricing Best Case Scenario: There is reason to doubt the incoming administration’s campaign pledge to ramp up defense spending, but the sector’s strong gains since election day in the absence of any policy details is likely a bit too soon. The Zacks Aerospace & Defense sector’s +7.9% gain since November 8th vs. the +5.2% gain for the S&P 500 index in that same time period reflects this optimism.

The sector is hardly cheap following these post-election gains. Over the last 5 years, the sector has traded as high as 18X forward 12-month earnings estimates and as low as 10.6X. It is currently trading at 17.6X forward 12-month EPS estimates, towards the high-end of this 5-year range. As such, further gains from here onwards will be hard to come by.

Regulatory Impediments: The Aerospace & Defense industry is subject to multiple regulatory standards in the markets they serve, including safety, fuel economy, emissions control and chemicals use. In addition, the industry must comply with regulations related to government contracting and international trade. In the U.S., several agencies within the federal government have jurisdiction over various aspects of the Aerospace & Defense industry. To comply with these, companies bear heavy costs.

Further, companies in this industry must manage price and environmental expectations in order to meet government requests for proposals (RFPs), which seek to align contract work with broader government goals. In trying to meet such regulations, at times, companies are compelled to forgo a part of their profits; which in turn affects the growth of the entire sector.

Economic Picture: The U.S. has been the world’s largest defense consumer since World War II. Iraq and Afghanistan wars in the past decade boosted spending, driving the U.S. defense market to historic heights. However, the winding down of those wars and severe pressure to lower the national debt burden following the country’s major financial distress since the Great Depression had cast a long shadow over the U.S. defense budget. Although the defense market received the latest two-year budgets with much enthusiasm, as it brought military stability, one cannot overlook the risk of an economic downturn.

A country’s ability to spend on defense is a function of its economic health. The same is true at the global level – the faster the global economy grows, the higher will be the defense spending. Following the global crisis in 2008, there was a marked shift in defense spending from the developed to the emerging countries.

As per a recently released report, the U.S. fiscal 2016 budget deficit is projected at $552 billion, or 3.3% of the nation’s total GDP, reflecting an increase of $153 billion from the previous year’s number. A slowdown in growth of federal revenues, as well as rising government spending, pushed the U.S. deficit up in fiscal 2016 for the first time since 2011, reversing the trend of falling deficits as the economy recovered in recent years.

Strong U.S. Dollar: A gradually recovering U.S. economy, slower global growth and expectations of more rate hikes from the U.S. Federal Reserve had led to the U.S dollar appreciation. This has affected U.S.-based companies as the strong dollar is not only showing up as a currency translation drag, but is also having a bearing on foreign military sales.

With the Fed most likely to hike rates this December, dollar should also be on an uptrend. As a result, U.S,-based defense companies earning from overseas operations will be deeply affected. A stronger dollar might also damage U.S. export competitiveness.

Will Weapons Programs Be Hit in Fiscal 2017 Budget?

The U.S. Department of Defense (DoD) announced this February that it plans to purchase fewer F-35 fighter jets from Lockheed Martin Corp. (LMT - Free Report) over the next five years than it had originally planned. The Pentagon’s next five-year plan, beginning fiscal 2017 through fiscal 2020, covers the purchase of 299 jets (down by 37 units from the previous expectation). Total funding – procurement, research, and development – has dropped from $11.602 billion in FY 2016 to $10.504 billion in the FY 2017 proposal.

Certain limitations on the budget related to training, personnel costs and force structure may have an implication on weapons programs in the fiscal 2017 budget plan.

Lockheed Martin Corp.’s F-35 fighter jet is undoubtedly the single-largest weapons program of the DoD. Apart from that, total funding proposal for the P-8A Poseidon program – procurement, research, and development – in FY 2017 dropped to $2.165 billion from $3.373 billion in FY 2016. Funding proposal for FY 2017 for Stryker, the Amphibious Combat Vehicle (ACV), DDG 51 Arleigh Burke destroyer along with Space Based Infrared System (SBIRS) and the DoD’s Global Positioning System (GPS) program has also witnessed a sharp decline.

Some defense suppliers may have to migrate their business models to other channels to offset the secular decline in weapons-related procurement.

Besides, the recent attacks that President-elect Trump has made against the F-35 project and The Boeing Company’s (BA) Air Force One program, slamming both of them to be ‘out of control’ cost projects; has been hurting the sentiment of defense investors. If Trump continues to indulge in skepticism against defense stocks this way, an adverse impact might be reflected in next fiscal year’s budget proposals. 

Intense CompetitionAerospace and defense companies compete among themselves for a finite number of small and large programs.

Moreover, China is developing space technologies aimed at blocking U.S. military communications, per a report commissioned by a panel formed by Congress. China’s goal is to become a space power as forceful as the U.S. and to promote a space industry equal to those in the U.S., Europe and Russia.

Given the looming headwinds, we advise investors against names that offer little growth/opportunity over the near term. These include companies for which estimate revision trends reflect a bearish sentiment.

We remain apprehensive of Zacks Rank #4 (Sell) stocks like BAE Systems plc (BAESY - Free Report) , Rockwell Collins, Inc. , TransDigm Group Inc. (TDG - Free Report) , Rolls Royce Holdings plc (RYCEY - Free Report) and Esterline Technologies Corp. . You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

In addition, we are skeptical of the Zacks Ranked #5 (Strong Sell) stock Astronics Corporation (ATRO - Free Report) .

Our Take

In “Will Global War on Terror Boost the Defense Industry?” we focused on the conditions that are expected to drive the industry forward.

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.

The fast-changing world with rising global uncertainty requires the defense sector to act with speed and flexibility. With careful management and prudent spending, the sector is expected to weather the headwinds.

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