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Aerospace & Defense Industry Outlook - March 2018

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U.S. aerospace and defense stocks have been rallying exceptionally in recent times, courtesy of an improving outlook for both the defense and commercial aerospace businesses. While increasing budget allocations in America -- in view of escalating geopolitical tensions worldwide -- have been boosting defense stocks, a steady improvement in air traffic has given a notable upward thrust to commercial airplane demand.

Currently, S&P Global Ratings expects the credit ratios of global aerospace and defense companies to improve in 2018 on moderate revenue growth and higher margins. With the United States being the largest supplier of defense equipment as well as commercial jets, there is no doubt that the U.S. aerospace and defense industry will be the greatest beneficiary.

Impressively, stocks in the Zacks Aerospace sector (a stand-alone sector) rallied 42% in the past year, significantly outperforming the S&P 500 index’s 16% gain. With a majority of macroeconomic factors favoring this industry, such outperformance can be expected to continue in the days ahead as well.

U.S. Defense Scenario

Widespread geopolitical tensions have been a key source of demand growth for the U.S. defense contractors for the last many years. While most of the demand earlier came from the nation itself and its developed counterparts like Europe, a recent trend of developing nations like India boosting defense spending has expanded these stocks’ growth prospects notably.

Additional factors like the advent of innovative technologies in warfare and their increased application, as well as increased demand for cost-efficient production, are driving revenue growth in the U.S. Aerospace and Defense industry.

In addition, macroeconomic statistics like the nation’s unemployment rate remaining at a low rate of 4.1% in February 2018 and a 0.2% rise in last month’s consumer price index (CPI) for all items have been favoring the economy’s growth. Evidently, the U.S. economy expanded an annualized 2.6% in the fourth quarter of 2017, driven by a solid 4.6% rise in domestic demand. Naturally, these have set the stage for more upside in the aerospace-defense industry, since a strong economy can better support defense funding.

However, a decline in skilled workforce and increasing competition with emerging nations like China that are vigorously engaged in unveiling their own defense equipment continue to pose as challenges for this industry. Nevertheless, its non-cyclical feature has always helped the industry to stay afloat.

Budget Uptrend

Needless to say, budget is the X-factor behind the rally of the defense stocks. Since President Trump’s election, the U.S. defense budget has been gaining notable upward traction, with the President being in favor of spending big on the nation’s security.

On Feb 12, 2018, the Pentagon unveiled the fiscal 2019 budget proposal outlined by President Trump that provisions spending of $716 billion on national security. Of the total, $686.1 billion is being kept as funding for the Pentagon. The budget includes $617.1 billion as base budget, highlighting a 17.8% increase from the 2018 current CR level and $69 billion for Overseas Contingency Operations.

Interestingly, the fiscal 2019 budget is the second full budget request from the President, initiating the rebuilding process for the U.S. military that Trump has been consistently emphasizing.

In September 2017,the U.S. Senate approved a $700 billion defense policy bill for 2018 that exceeded the nation’s statutory budget cap. No doubt, on approval, the fiscal 2019 budget which exceeds this appropriation bill will add further impetus to the industry’s growth.

Commercial Jetliner Demand

The large numbers of new program launches and significant increases in production rates have increased revenues of many firms in the commercial aerospace market. Notably, rapid growth in commercial passenger and freight traffic has been boosting the production rates of commercial jets. In particular, single-aisle jets compared with their wide-body counterparts have been the major driver of jetliner demand owing to the global popularity of the low-cost carrier business model.

Air traffic has expanded manifold in the past few years in emerging markets like Asia, with countries like India and Japan enhancing their business realm. This has expanded demand for commercial fleet of jet-makers like Boeing and Airbus significantly in Asiatic countries.

Zacks Industry Rank – Mixed Bag

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 industries is that, we put our X industries (all 256 of them) into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank.)

Aerospace is one of the 16 broad Zacks sectors within the Zacks Industry classification. Aerospace is further sub-divided into three industries at the expanded level: aerospace/defense, aerospace/defense equipment and electronics-military.

Aerospace/defense, with a Zacks Industry Rank #53, as well as aerospace/defense equipment with a Zacks Industry Rank #112, remain in the top half.  However, electronics-military with a Zacks Industry Rank #224 came in the bottom half.

Earnings Review and Outlook

Amid headwinds, the Aerospace sector held up well in the fourth quarter. The earnings beat ratio for the stocks in this space (percentage of companies coming up with positive surprises) was an impressive 81.8%, while the revenue beat ratio was 45.5%. When compared to the S&P 500’s earnings beat ratio of 77.4%, Aerospace stocks performed better in the fourth quarter.

Going forward, the picture for the first quarter of 2018 is impressive. The sector’s earnings are expected to improve a solid 14% in the first quarter, while revenues are expected to see a 4.6% increase (as of Mar 16, 2018). Margins for this sector are expected to rise 0.7%. Notably, this sector is one out of the 14 of the 16 Zacks sectors that are expected to exhibit positive earnings growth this quarter.

Defense Stocks Worth Adding

Investors might keep a watch on the following defense majors that have the financial strength to withstand headwinds and reflect an impressive earnings scorecard.

The Boeing Company (BA - Free Report) has a long-term earnings growth projection of 13.8%. This stock registered an average positive earnings surprise of 20.69% in the trailing four quarters. Its 2018 earnings estimates moved up 16.7% in the last 60 days. The company currently sports a Zacks Rank #1 (Strong Buy).

Huntington Ingalls Industries, Inc. (HII - Free Report) has a long-term earnings growth projection of 15%. This stock registered an average positive earnings surprise of 3.85% in the trailing four quarters. Its 2018 earnings estimates moved up 39.7% in the last 60 days. The company currently sports a Zacks Rank #1.

Wesco Aircraft Holdings, Inc. (WAIR - Free Report) has a long-term earnings growth projection of 12%. This stock registered positive earnings surprise of 25% in the prior quarter. Its 2018 earnings estimates moved up 9.4% in the last 60 days. Wesco Aircraft currently carries a Zacks Rank #2 (Buy). You can seethe complete list of today’s Zacks #1 Rank stocks here.

Summing Up

Increasing terrorist attacks across the globe have spurred nations to make heavy investments in their aerospace and defense industry. Some say it’s a game of power, while others say it’s just a protective measure.

If we look at the big picture, the U.S. aerospace and defense industry is a direct beneficiary of a volatile and uncertain geopolitical global backdrop, characterized by terrorist threats, civil wars and border disputes. On the other hand, increased routes for travelers as well as trade activity are fueling air traffic growth, thereby boosting commercial aerospace stocks.

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