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Will the Defense Industry Suffer in the Long Run?

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Stocks in the U.S. aerospace and defense industry have been hitting new highs lately, taking a strong rebound from their ordeals over last couple of years due to continued budget cuts by the U.S. Department of Defense (DoD).

No doubt, President Trump’s March budgetary proposals and a few other steps taken by the new American administration are in favor of this industry. Measures like signing an arms deal with the Saudis this May have been the primary driving force.

Nevertheless, there remain quite a few challenges in this industry that may pose serious hindrance to its growth path. First and foremost, the fiscal 2018 (FY 2018) budget proposal contains some loopholes that question the very stability of such high spending promises made by Trump in defense.

Then there lies some issues in terms of lack of technical graduates in the industry. Moreover, various regulations imposed on international trade of defense equipment remain significant barriers to Aerospace sector’s growth. Also, many stocks in this space likely have reached levels when valuation concerns start taking center stage.  

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

Market Pricing Scenario: Obviously, the Trump administration’s pledge to substantially ramp up defense spending has given a solid boost to the U.S. aerospace and defense industry. However, the aerospace sector has hardly been cheap after Trump took over. In fact, over the last five years, the sector traded as high as 19.8x forward 12-month earnings estimates and as low as 10.8x. It is currently trading at 19.8x forward 12-month EPS estimates, in line with the high-end of this five-year range and also higher than the S&P 500 index’s 18.4x forward 12-month EPS estimates. Other valuation metrics like price to book, for example, are similarly towards the high end of historical trading ranges.

All of this indicates that valuations in the aerospace sector may already have reached levels that limit further upside from current levels.

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.

In addition, certain U.S. government contracts span one or more base years and multiple option years. The U.S. government generally has the right not to exercise option periods and may not exercise an option period for various reasons, which in turn might hamper revenue growth of defense corporations.

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.

Budget Loopholes: The FY 2018 defense budget proposal and the appropriations presented by Trump’s administration for FY 2017 are expected to boost defense stocks.

Yet, Trump’s FY 2018 budget proposal seems to be a threat to the growth of the nation’s economy. While the ‘America First Budget’ proposed a 10% hike in defense spending, to avoid any further budget deficit, it includes a simultaneous decline in spending in non-defense programs, particularly foreign aid, agriculture, commerce, education, energy, environment protection agency (EPA) and health.

Of course, increasing fiscal budget deficit puts an economy under huge debt, thereby slowing down its growth trajectory. But to ensure a balanced budget, it is not wise to sacrifice the other pillars of the economy. Stability in economy is not guaranteed only by the departments of justice, defense and homeland security. Neither does social security depend only on the strength of a defense system. Qualities of health, education as well as environmental services are also crucial to a nation’s well-being. Many analysts fear that such deep cuts in these basic-amenities sectors might shake the very foundation of the U.S. economy.

Among the sectors that will suffer the most, the EPA’s operating budget would be cut by 25%, eliminating approximately 3,000 jobs and reducing its total staff from 15,000 to 12,000. This would not only raise the unemployment rate but also hurt programs dealing with air and water pollution and climate change research.

Indeed, Trump’s budget seems to have created an economic conflict in America, with concerns that reducing funds for these important industries might do more harm than good to the economy. Going forward, under Trump’s planned budget cuts, federal spending is likely to see a $10.5 trillion reduction over 10 years. However, if the reduction is not even among all federal departments, everyone will suffer severe economic repercussions in times of recession and the defense stocks will not be out of harm’s way, then.

Workforce Challenges: The aerospace and defense industry needs a highly skilled and productive workforce to maintain stability. Yet of late, the industry is facing impending retirements and a shortage of trained technical graduates, a situation that can worsen within the next decade. The Aviation Week & Space Technology 2016 Aerospace & Defense Workforce Study conducted in collaboration with Aerospace Industries Association (AIA) found that nearly 27% of the nation’s workers in this industry are over the age of 55, i.e. close to retirement.

While outsourcing can be opted for addressing this issue, in defense, it is mandatory that most design work on military systems be done by U.S. citizens for security concerns. Thus the country acutely needs developed technical talent, to maintain its world-class aerospace workforce.

In this respect, the Commission on the Future of the U.S. Aerospace Industry earlier recommended the nation to immediately reverse the decline in its workforce and promote the growth of a scientifically and technologically trained aerospace labor force. Obviously, the U.S. government has been taking measures to revive its workforce, but if it fails, the nation’s security as well as its ability to remain a global leader will be threatened.

Intense Competition: Aerospace and defense companies vie among themselves for a finite number of small and large programs.

Moreover, in the international space, a handful of emerging nations are offering stiff competition to U.S. defense contractors. For instance, 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. and Europe.

In the same line of action, as per a report by CNBC, Russian defense officials have acknowledged deploying radar-imagery jammers and developing laser weapons designed to blind U.S. intelligence and ballistic missile defense satellites. Russia and China continue to pursue weapon systems capable of destroying satellites on orbit, placing U.S. satellites at greater risk for the next few years.

Moreover, being the second largest nation in terms of military expense, China has been engaged in production of its indigenous defense equipment, to make its economy even more powerful. The Aviation Industry Corporation of China (AVIC) produces the J-20 stealth fighter, FC-1, and FC-8 fighters, the 5th-generation FC-31 stealth fighter, as well as aerial reconnaissance and attack drones.

North Korea has also been giving the U.S. a hard time lately on the defense frontier. For the last few months, the two countries have been engaged in a hostile cross-border missile rift. This aggravated when U.S. Ambassador to the U.N. Nikki Haley condemned North Korea’s first launch of ballistic missile capable of reaching the continental U.S. as “a clear and sharp military escalation” against the nation. 

Stocks to Avoid

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 Engility Holdings, Inc. (EGL - Free Report) . You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

In addition, we are skeptical of these Zacks Ranked #5 (Strong Sell) stocks: Wesco Aircraft Holdings, Inc. (WAIR - Free Report) , AAR Corp. (AIR - Free Report) and Triumph Group, Inc. (TGI - Free Report) .

To Conclude

It is true that the aerospace & defense industry has remained mostly stable amid economic downturns, thanks to its non-cyclical nature and rising geopolitical tensions worldwide. Yet, it will be unwise to overlook issues hovering over this industry like intensifying global competition, rapid technological upgrades adopted by foreign nations, a declining workforce and a few more that we have mentioned above. Going forward, we believe that careful management and prudent spending will help the industry to overcome its headwinds.

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