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Aerospace & Defense Stock Outlook - Aug 2016

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The importance of the aerospace & defense industry stems from the strategic role it plays in our country’s security. As threats turn into ever new shapes involving asymmetric, air-sea power, cyber, urban, non-state organizations and many more, the defense capabilities of a country need to morph accordingly to contain them.

A politically unstable world has led to various nations stepping up their defense capabilities. The direct beneficiaries of a volatile geo-economy are undoubtedly the aerospace and defense players. The U.S. defense firms have particularly tasted success in the ”rest of the world.” Countries allied to U.S. policy are spending substantially on sophisticated artillery to wage the war on terror and sectarian forces. The crisis has been acutely felt with the meteoric rise of the Islamic State of Iraq and Syria (ISIS), an organization President Obama termed “the network of death.”

Moreover, the aerospace and defense industry has gained from fleet renewals at airlines worldwide. Demand for more fuel-efficient aircraft, a growing international market and increasing application of unmanned aircraft in warfare today have driven up sales in this sector.

On top of this, the latest budget agreement is a net positive for defense players. However, readings on the U.S. economy since the beginning of 2016 have been mixed. While many indicators including labor market data, declining unemployment rate, moderate expansion of consumer spending and housing market recovery were favorable, a continued decline in manufacturing and net exports owing to slow global growth and the significant appreciation of the dollar can’t be ignored.

The U.S. economy showed a weak performance in the second quarter after a weaker start to the year as companies narrowed down inventories and remained wary of investing amid unstable global demand. Gross domestic product or GDP grew at a seasonally adjusted annual rate of 1.2% in the second quarter.

The gain marks only a slight increase from the first quarter, when GDP advanced at a downwardly revised 0.8% pace. Adding more to the woes, the economy has grown at less than a 2% pace for three straight quarters. That said, the smaller inventory build is a good signal for growth in the quarters ahead.

Budget Updates

On Feb 9, 2016, President Obama unveiled the Pentagon's fiscal year 2017 (FY 2017) budget request that is intended to reshape spending priorities taking into account new and evolving challenges.

Obama’s fiscal year 2017 budget proposal of $582.7 billion for the Pentagon includes a base budget of $523.9 billion. This is a $2.2 billion increase over the FY 2016 enacted budget of $521.7 billion. Additionally, it provided $58.8 billion in funding for the Pentagon’s separate war fund, the overseas contingency operations (“OCO”) fund, almost the same as the FY 2016 enacted level of $58.6 billion. The combined request represents a total increase of $2.4 billion or less than 1% over FY 2016 enacted levels.

The budget proposal mainly addresses five key challenges, namely, the threat of Russian aggression in Europe as well as that of China in the Asia-Pacific, North Korea to the U.S. and its Pacific allies, Iran’s influence against allies in the Gulf, and the ongoing fight against the Islamic State.

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 257+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #88 and lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative.

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

Aerospace/defense is positive with a Zacks Industry Rank #70. The Zacks Industry Rank for Electric-military is at #101 out of 257 industries, which puts it in a neutral zone. Aerospace/defense equipment with a Zacks Industry Rank #211 comes in the bottom one-third or in the negative territory of all Zacks industries.

Earnings Review and Outlook

Every fiscal year, no matter how constrained the funding picture, the Pentagon almost always gets its way. Despite headwinds, the aerospace and defense sector held up well in the ongoing second quarter. As of Jul 29, 2016, 90% of the companies in the S&P 500 index have already come up with their second-quarter results. The earnings beat ratio (percentage of companies coming out with positive surprises) was at an impressive 88.9%, while the revenue beat ratio was trending at 66.7%.

While earnings declined 28.8%, revenues grew 2.7% over the prior year. The top contractors, such as, Lockheed Martin Corp. (LMT - Free Report) , Northrop Grumman Corp. (NOC - Free Report) , General Dynamics Corp. (GD - Free Report) and Raytheon Co. (RTN - Free Report) have posted impressive results given elevated geopolitical risks.

However, Boeing, the world's largest plane maker, reported the first quarterly net loss in nearly seven years. Its quarterly numbers were hit by after-tax charges in relation to three separate programs: the 787, the 747 and the KC-46 tanker aircraft program. Boeing's KC-46 tanker program for the U.S. Air Force is pushed back from Aug 2017 to Jan 2018 due to test flight problems.

Meanwhile, the earnings picture for the third quarter of 2016 and for the full year looks grim. The sector’s earnings are expected to decline 3.7% in the third quarter. Revenues are expected to see a 1% decline. For 2016, the sector’s earnings will likely decrease 5.9% while revenues are expected to witness 2% growth (versus 2.5% growth registered in 2015).

In comparison, for the S&P 500, earnings are expected to decline at a rate of 1.2% while revenues are likely to witness 1.6% growth in the third quarter. For 2016, the S&P 500 will register a 2.1% decline in both earnings and revenues.

To Sum Up

While there are various other variants that affect the stock market, the terror spawned by ISIS sparked renewed anger around the world following the Paris and Brussels attacks. This has drawn investors’ attention once again to defense stocks.

Amid the ups and downs of Federal budgets, we advise investors to consider this trouble-free and proven investment strategy of putting in money where the fundamentals are strong. Despite a multitude of challenges, the long-term outlook for the defense industry looks stable in a volatile political climate.

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