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Will Trade Worries Hurt Aerospace & Defense Growth?

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Stocks in the U.S. aerospace and defense industry have been strong performers over the past year-plus, particularly since the November 2016 election. Since November 8th 2016, stocks in the Zacks Aerospace & Defense sector have gained +63.3% through the market’s close on March 23rd, handily outperforming the S&P 500 index’s +24.5% gain in the same time period.

One would expect this momentum to continue going forward, particularly given the Trump administration’s favorable posture towards the space that has been showing up in greater budgetary allocations. But the sector’s recent stock market struggles suggest that market participants remain skeptical about the momentum continuing.

The Trump administration’s restrictive trade policies have emerged as a major headwind for the sector, with the issue likely having plenty of staying power. Valuation concerns have also taken center stage, particularly following the sector’s run up over the past year.  

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

Market Pricing Scenario: The Trump administration’s pledge to substantially ramp up defense spending has been a big reason for the U.S. aerospace and defense industry’s strong gains over the past year. This has pushed the group’s valuation levels much higher.

Over the last five years, the sector has traded as high as 22x forward 12-month earnings estimates and as low as 11.9x. It is currently trading at 20.3x forward 12-month EPS estimates, near the high-end of this five-year range and above the S&P 500 index’s 17.4x forward 12-month EPS estimates.

Other conventional valuation metrics similarly show that Aerospace stocks are no longer cheap. Given this valuation picture, further upside from current levels may 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 United States, 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 government contracts span one or more base years and multiple option years. The 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.

Recent Tariff Proposal: Aluminum and steel are the basic raw materials required for the manufacturing of aircraft as well as other defense products like rockets, missiles and tankers, to name a few.

According to the U.S. Geological Survey, operational aluminum smelters in the United States have declined from 23 in 1993 to five in 2018. Per a Commerce Department report only one of these smelters make the high-purity aluminum needed for fighter jets. Aircraft manufacturers as well as defense majors rely on foreign imports to develop high-end weaponries. Per a report by The Washington Post, U.S. companies import 90% of aluminum that is needed to manufacture products as diverse as beer cans and fighter jets.

However, steel in the United States is used to a much lesser extent by Aerospace companies compared to aluminum. The United States imports only about one-third of its steel required for manufacturing jets and defense equipment (as per the New York Times).

Therefore, the imposition is likely to have a significant impact on the major players in the U.S. Aerospace & Defense space. The Aerospace Industries Association believes that the imposition might lead to a marketplace retaliation and has thus extended a critical review of the tariff plan. In particular, its CEO believes that the tariff will adversely impact the Aerospace-Defense space by raising costs and disrupting supply chains, putting the U.S. global competitiveness at risk.

Budget Loopholes: The FY 2019 defense budget proposal is a big positive for the sector. But the weak allocations for other social sectors have sharpened the traditional ‘guns vs. butter’ debate, which could potentially be a negative for the space in the long run. Some economists also see the prospect of increased budget deficits in the years ahead, owing to increased government spending on defense and reduced revenues due to the tax cuts, as a net negative for the U.S. economy that could result in reduced defense allocations in the years ahead.  

Workforce Challenges: The Aerospace & Defense industry needs a highly skilled and productive workforce to maintain stability. Yet lately, the industry is facing impending retirements, witnessing a relatively high attrition rate for new employees and a greater proportion of older workers. As per the Aviation Week & Space Technology 2017 Aerospace & Defense Workforce Study, approximately 60% of employees in this industry are over the age of 45 versus 44% in the overall U.S. workforce. Conversely, approximately 42% of employees are under the age of 44 versus 56% in the overall workforce.

Moreover, we see shortages of trained technical graduates on the rise, a situation that can worsen within the next decade. There’s no denying the fact that such talent shortage will have a moderate or extreme impact on production levels to meet growing customer demand. To compensate, forced overtime is often imposed, which eventually does not lead to any positive outcome.

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.

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 United States and to promote a space industry equal to those in the United States and Europe. Moreover, the country has raised its 2018 defense budget by 8.1%, hinting at more development in the other aspects of its defense department.

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.

In commercial jet space also, China is trying tirelessly to enter the market. In this line, recently, the Commercial Aircraft Corp of China announced that it is aiming to make the first delivery of its C919 single-aisle jet in 2021, despite delays in flight testing. If successful, this jet’s advent may hamper other renowned jet makers like Boeing and Airbus’ business in Asia-Pacific, with the single-aisle jet being in more vogue than wide-body jets.

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 skeptical of Engility Holdings, Inc. (EGL - Free Report) , which carries a Zacks Rank #4 (Sell).

You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

To Conclude

Historically, the Aerospace & Defense industry has remained mostly stable amid economic downturns worldwide, thanks to its non-cyclical nature and rising geopolitical tensions worldwide. Yet, it will be unwise to overlook issues hovering on this industry like the recent import tariff on aluminum, rapid technological upgrade 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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