The start to 2017 for the U.S. economy lacked luster, in sharp contrast to strong economic growth promised by President Trump’s administration. The economy grew at a meager annual rate of 0.7% last quarter, lagging the annual growth target of 4% set by Trump. As far as the Aerospace-Defense industry is concerned, the first quarter of 2017 has been quite impressive, courtesy of the raised fiscal 2018 budget proposal and additional appropriations requested by the new administration.

The major indices of this industry – the S&P 500 Aerospace & Defense Index as well as the Dow Jones U.S. Aerospace & Defense Index – rallied over 7% during the first quarter.  Surprisingly, a few adverse factors like regulatory impediments and Trump’s cost-cutting crusade against America’s top defense contractors like Lockheed Martin Corp. (LMT) and The Boeing Company (BA) could not mar the industry’s prospects.

Trump’s Budget Effect on Defense Stocks

In Mar 2017, Trump unveiled the Pentagon's fiscal 2018 defense budget proposal of $639 billion, reflecting a significant $52 billion increase over the fiscal 2017 budget.

Along with this came an additional appropriation for fiscal 2017 that proposed an increase in the defense budget by $30 billion–$24.9 billion in base budget and $5.1 billion in overseas funds. In addition, these amendments support future investment capabilities worth $15.5 billion in the aerospace-defense industry to improve the nation’s near-term and mid-term combat promptness to counter threats. No doubt, these budget proposals pumped up confidence in investors sorting out defense stocks as their favored option.

Moreover, Trump urged the North Atlantic Treaty Organization or NATO member nations to contribute more to the organization’s defense funds, claiming how a few nations owe ‘vast sums’ to the U.S. and NATO. Now U.S. being the largest contributor to NATO (about 72%), the nation’s pressure on other members to spend more on defense might lead to increased defense funds.

Naturally, this will boost growth for U.S. defense biggies, courtesy of the varied and vast number of defense products and allied equipment they supply to the global market.

Q1 Performance and Other Developments

Notably, 90% of the total S&P 500 companies in the broader Aerospace sector have reported their earnings as of Apr 28, 2017. With a beat ratio of 77.8%, total earnings for these companies improved 9.5% year over year. Revenues for these companies also came up with a beat ratio of 44.4%.  

Now that a handful of leading defense players has posted their Q1 results, a clearer picture of the entire earnings season has emerged. As of Apr 28, 2017, earnings growth expectation for the sector as a whole is pegged at 9.1% versus 11.2% for the S&P 500 Index, probably marred by the 2.1% top-line decline projected for the same.

Here, it is imperative to mention that certain economic factors are working in favor of defense stocks. For instance, macroeconomic statistics like improving employment in the private sector, more-or-less stabilized oil price over the past few months and increasing core consumer price inflation boosted consumer confidence and is being reflected in increased consumer spending.

Moreover, demand for more fuel-efficient aircraft, growing international market and increasing application for unmanned aircraft in warfare have driven sales for primary sector players. The recent uptick in geopolitical uncertainty, both in developed as well as emerging nations, has also been a growth driver for this industry.

Although rising interest rates and the strengthening of U.S. dollar continue to act as dampeners for this industry, its non-cyclical feature helps overcome all oddities.  
Picking the Right Stocks    

With the existence of a number of industry players, finding the right stocks that have the potential to beat earnings could be a daunting task. Our proprietary methodology, however, makes it fairly simple for you. You could narrow down the list of choices by looking at stocks that have the combination of a favorable Zacks Rank #1 (Strong Buy), 2 (Buy) or 3 (Hold) and a positive Earnings ESP.

Earnings ESP is our proprietary methodology for determining stocks that have the best chance to surprise with their next earnings announcement. It provides the percentage difference between the Most Accurate estimate and the Zacks Consensus Estimate.

Our research shows that for stocks with the above-mentioned combination, the chance of a positive earnings surprise is as high as 70%.

Our Choices

Given below are three defense primes that have the right combination of elements to post an earnings beat this quarter. Also, these companies are expected to report their first-quarter 2017 results on May 4.

Huntington Ingalls Industries, Inc. (HII Quick QuoteHII - Free Report) – Newport News, VA-based Huntington Ingalls is the largest military shipbuilder in the U.S. It designs, builds and maintains nuclear-powered ships such as aircraft carriers and submarines, and non-nuclear ships, such as surface combatants, expeditionary warfare/amphibious assault and coastal defense surface ships.

Notably, the company surpassed the Zacks Consensus Estimate in three of the preceding four quarters, with an average positive earnings surprise of 19.85%. This Zacks Rank #2 stock has an Earnings ESP of +0.37%. You can uncover the best stocks to buy or sell before they’re reported with our Earnings ESP Filter.

Leidos Holdings, Inc. (LDOS Quick QuoteLDOS - Free Report) – Reston, VA-based Leidos Holdings provides technology and engineering solutions in the defense, intelligence, homeland security, civil, and health markets.

Notably, the company surpassed the Zacks Consensus Estimate in two of the preceding four quarters, with an average positive earnings surprise of 5.80%. This Zacks Rank #3 stock has an Earnings ESP of +1.28%. You can see the complete list of today’s Zacks #1 Rank stocks here.

Orbital ATK, Inc. – Headquartered in Dulles, VA, Orbital ATK designs, builds and delivers space, defense and aviation-related systems to customers around the world, both as a prime contractor and a merchant supplier. Its main products include launch vehicles and related propulsion systems; satellites and associated components and services; composite aerospace structures; tactical missiles, subsystems and defense electronics; and precision weapons, armament systems and ammunition.

The company has a long-term earnings growth expectation of 10%. Orbital ATK currently has an Earnings ESP of +2.22% and a Zacks Rank #3.

Looking Ahead

Although the U.S. economy progressed at a slow pace in Q1, the macroeconomic factors seem quite constructive. In the words of Fed Chairperson Janet Yellen, the central bank has “confidence in the robustness of the economy and its resilience to shocks.” So investing in a non-cyclical sector like defense might be a good idea now.

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