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Aerospace-Defense Outlook: Air Traffic Up, Labor Woes Persist

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Widespread geopolitical tensions that are prompting nations, both developed as well as developing, to rapidly expand their arsenal should keep the outlook for the U.S. aerospace and defense stocks favorable. On top of that, a steady improvement in global air traffic has given a boost to commercial airplane demand, which is another positive for this industry. However, the industry faces increased competition from emerging global players, especially China and Russia, as these nations are vigorously developing advanced technologies to block U.S. intelligence satellites. If successful, these rival technologies could not only challenge the U.S. defense operators' hold on the market but also pose a threat to United States’ security.

Moreover, the industry faces impending retirements and a shortage of trained technical graduates. Per a recent report by AIA, employment in this industry fell 1.6% in the last five years.If the trend persists, it may impact business growth of industry players in the near term.

Nevertheless, with the United States being the largest supplier of defense equipment, it is undoubtedly a golden era for U.S. aerospace and defense stocks. The defense majors are expanding their foreign markets rapidly, taking advantage of regional tensions in the Middle East. According to the latest report from Aerospace Industries Association (AIA), the United States led global exports in the aerospace and defense industry in 2017, accounting for 34% of the industry’s total export. We expect this winning streak to continue.

Industry Outperforms Market

Looking at shareholder returns over the past year, it is evident that issues like lack of skilled labor as well as foreign threats have failed to dent investors’ confidence in the U.S. aerospace and defense industry. While increasing budget allocations in America under President Trump has significantly boosted the prospects of defense stocks, increased trade activity over the last decade, thanks to globalization, has bolstered the commercial aerospace segment.

Impressively, S&P Global Ratings expects the credit profiles of global aerospace and defense companies to improve in 2018 on moderate revenue growth and higher margins. This should further encourage investors to add stocks from this industry to their portfolio and in turn keep the industry’s momentum alive.

The Zacks Aerospace-Defense Industry, which is a 13-stock group within the broader Zacks Aerospace Sector, has outperformed both the S&P 500 as well as its own sector over the past year.

While the stocks in this industry have collectively rallied 22.9%, the Zacks S&P 500 Composite and Zacks Aerospace Sector have gained 18.1% and 21.3%, respectively.

One-Year Price Performance

Optimistic Valuation for Aerospace-Defense Stocks

Impressively, even after delivering an outperformance over the past year, valuation for this industry still looks reasonable, when compared to the market. One might get a good sense of the industry’s relative valuation by looking at its enterprise-to-sales ratio (EV/Sales), which is an appropriate multiple for valuing capital intensive stocks like those in the aerospace-defense industry.

This ratio essentially measures a stock’s current market value, including its debt, relative to its sales value.

The industry currently has a trailing 12-month EV/Sales ratio of 1.66X, which is near the median of the multiple’s level over the past year. When compared with the highest level of 1.83X and the lowest level of 1.40X over that period, there is still room for an upside.

The space also looks inexpensive when compared with the market at large, as the trailing 12-month EV/Sales ratio for the S&P 500 is 3.12X and the median level is 2.97X.

Enterprise Value-Sales Ratio (TTM)

However,a comparison of the group’s EV/Sales ratio with that of its broader sector ensures that the group is trading at a premium. The Zacks Aerospace Sector’s trailing 12-month EV/Sales ratio of 1.52X and the median level of 1.49X for the same period are way below the Zacks Aerospace-Defense Industry’s respective ratios.

While this comparison might initially seem a bit disappointing, we should keep in mind that a higher EV/Sales ratio signals that the future sales prospects of the industry are attractive, when compared to that of the sector. In fact, since the industry’s EV/Sales ratio came in lower than that of the broader market, we should be optimistic that there’s still enough room left for aerospace-defense equipment stocks’ sale growth in the days ahead.

Enterprise Value-Sales Ratio (TTM)

Outperformance Should Continue Due to Solid Earnings Outlook

The factors helping the U.S. aerospace and defense industry’s positive momentum to remain in place include the latest budget proposals from the Pentagon. Increased defense spending by other nations, particularly emerging markets like India, and greater awareness of cyber security vulnerabilities worldwide should continue to support the stocks’ prospects in this industry in the near future.

Now, what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. While the above ratio analysis shows that there is a solid value-oriented path ahead, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.

One reliable measure that can help investors understand the industry’s prospects for a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company’s earnings outlook significantly influences the performance of its stock.

One could get a good sense of a company’s earnings outlook by comparing the consensus earnings expectation for the current financial year with the last year’s reported number but an effective measure could be the magnitude and direction of the recent change in earnings estimates.

Encouragingly, both the consensus earnings estimate for the Zacks Aerospace-Defense industry of $10.54 per share as well as the trend in earnings estimate revisions indicates year-over-year improvement.

Price and Consensus: Zacks Aerospace-Defense industry

Looking at the aggregate earnings estimate revisions, it appears that analysts continue to be confident about this group’s earnings potential.

The consensus EPS estimate for the current fiscal year has been revised 2.8% upward since May 31, 2018.

Current Fiscal Year EPS Estimate Revisions

Zacks Industry Rank Indicates Growth Prospects

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates continued outperformance in the near term.

The Zacks Aerospace-Defense industry currently carries a Zacks Industry Rank #98, which places it at the top 38% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Our proprietary Heat Map shows that the industry’s rank has remained favorable over the past five weeks.

Aerospace-Defense Stocks Promise Long-Term Growth

Not only do the near-term prospects appear encouraging for investors, the long-term (3-5 years) EPS growth estimate for the Zacks Aerospace-Defense industry also appears promising. The group’s mean estimate of long-term EPS growth rate has been increasing since February 2018 to reach the current level of 11.8%. This compares with 9.8% for the Zacks S&P 500 composite.

Mean Estimate of Long-Term EPS Growth Rate

In fact, the basis of this long-term EPS growth could be the recovery in gross profit that the aerospace-defense stocks have been witnessing since the end of 2016.

Bottom Line

While a few analysts remain concerned in relation to skilled labor shortage in the U.S. Aerospace-Defense industry, to address this issue, in July 2018, a handful of major U.S. aerospace and defense contractors like Boeing, General Dynamics and Huntington Ingalls pledged to enhance employment opportunities in the industry. We expect such initiatives to mitigate this issue of labor shortage going ahead.

Moreover, macroeconomic statistics like the nation’s declining unemployment rate as well as improving GDP growth are boosting the economy’s growth prospects all the more. Naturally, these have set the stage for more upside in the Aerospace-Defense industry, since a strong economy can better support defense funding. In terms of commercial segment, demand is being driven by rising passenger traffic, as well as a rapidly growing need for new jets. This is because a big fleet of old airplanes is set to retire in the next couple of years.

Given its favorable industry rank and price performance history, investors may bet on a few stocks in this space that exhibit a strong earnings outlook, taking advantage of the optimistic valuation trend.

Considering this space’s long-term growth prospects, below we have mentioned three Aerospace-Defense stocks that have a strong earnings outlook. These stocks have a favorable Zacks Rank #2 (Buy) and have been witnessing positive earnings estimate revisions. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Engility Holdings, Inc. (EGL - Free Report) : The stock of this Chantilly, VA-based provides government services in engineering, professional support and mission support to customers in the U.S. Department of Defense, Federal civilian agencies and allied foreign governments. The stock has gained 19% in the past year. The Zacks Consensus Estimate for the current fiscal-year EPS increased 16.1% in the last 60 days.

Price and Consensus: EGL

Huntington Ingalls Industries, Inc. (HII - Free Report) : The consensus EPS estimate for this Newport News, VA-based military shipbuilder and submarine manufacturer moved 6.4% higher for the current year over the last 60 days. The stock has rallied 21.6% over the past year.

Price and Consensus: HII

There are also a few stocks carrying a Zacks Rank #3 (Hold), in the industry which investors may want to hold on to.

The Boeing Company (BA - Free Report) : The consensus EPS estimate for this Chicago-based aircraft manufacturer moved 0.2% higher for the current year over the last 30 days. The stock has rallied 49.1% over the past year.

Price and Consensus: BA

Lockheed Martin Corp (LMT - Free Report) : Being the largest defense contractor in the world, Lockheed Martin’s consensus EPS estimate moved 5.7% higher for the current year over the last 60 days. The stock has gained 6.8% over the past year.

Price and Consensus: LMT

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