Defense Industry Majors Outwit the Sequester - Industry Outlook

By Zacks | Updated August 14, 2014 AAA

Overview

The aerospace and defense sector is up against an apathetic market as military budgets remain under pressure in the U.S. thanks to sequestration. The sequester that went into effect at the start of Mar 2013 will cut spending by a total of approximately $1.1 trillion over the eight-year period from 2013 to 2021. This is bound to affect the sector’s 2014 top and bottom line.

Nonetheless, the industry has emerged relatively unscathed due to fleet renewals at airlines worldwide with more fuel efficient aircraft, a growing international market for the F-35 Joint Strike Fighter and increasing application of unmanned aircraft in warfare today.

In spite of the weak demand outlook in the defense sector, the U.S. budget level has become clearer through at least FY15.

Offsetting Sequestration

Given the challenges, the defense primes are working on (i) how to grow profitably from diminishing Defense Department budgets and (ii) slash costs for maintaining a satisfactory financial condition.  

To that end, the defense primes are seen to diversify their businesses in other areas besides defense. A focus on research and development is also helping these companies to develop next generation technologies essential in a climate of fewer programs and reduced budgets.

Defense companies will increasingly be required to come up with next generation intelligence, surveillance and reconnaissance (ISR) technologies. The contractors specializing in space systems will continue to gain from the Pentagon’s increasing focus on its space division to counter emerging security threats.

The big defense operators are also expanding their operations through acquisitions and foreign orders. Foreign Military Sales (FMS) remain the key tool for expanding their top line. The ongoing Iraqi civil war, escalating tensions in Eastern Europe and demand for defense products in the Middle East and other Asian nations keep alive the hopes for this sector. A number of emerging markets as well as nations such as India, Japan, the United Arab Emirates, Saudi Arabia and Brazil are boosting defense spending and generating business for the U.S. aerospace and defense companies.

To maintain margins in a declining revenue environment, costs need to shrink. The operators are busy restructuring their businesses and engaging in prudent acquisitions. Another ploy utilized by these companies to avert budget austerities is to steadily diversify into the commercial aviation market. Commercial aviation is a comparatively newer industry, when compared to defense, with the sky as its literal limit. Increasing mobility in the emerging markets continue to drive this space.

Budget Update

In a bill passed in Jul 2014, the defense subcommittee of the Senate Appropriations Committee provided $549.3 billion to the Department of Defense for fiscal year 2015. The appropriation includes both the base budget as well as the Overseas Contingency Operations (OCO) fund. This compares unfavorably with $572 billion enacted in fiscal year 2014 and $550.7 billion in the President’s budget request. The fiscal 2015 base budget appropriation is $489.6 billion with the balance $59.7 billion going to the OCO fund. For fiscal 2014, the enacted OCO was $85.2 billion.

OCO is essentially government-speak for foreign wars and war on terror operations.

Zacks Industry Rank

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 260+ 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. To learn more visit: About Zacks Industry Rank.

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.

Zacks Industry Rank for aerospace/defense is at #77 out of 260 industries, which puts it in a positive light. Aerospace/defense equipment with a Zacks Industry Rank #77 also comes under the same zone. However, electric-military lies in the bottom one-third of all Zacks industries, with a Zacks Industry Rank #224.

Hence, the general outlook for the aerospace sector is on the whole positive. Investors should however be a little wary of the bearish electric-military sub-industry.

Earnings Review and Outlook

In retrospect, with more than six months of the year behind us, second-quarter 2014 results from the defense primes have grabbed the headlines. Although the defense contractors witnessed lower revenues in the quarter, the picture was overall reassuring with a number of earnings beats, braving issues like sequestration, budget cuts and cancellation of big-ticket programs. There was also some improvement on the guidance front.

In the broader aerospace and defense sector, all the companies have by now reported Q2 results with the earnings beat ratio (percentage of companies coming out with positive surprises) coming in at 55.6% and the revenue beat ratio at 44.4%.

The sector has witnessed a year-over-year earnings increase of 10.7% despite the 0.7% revenue decline. So far, this compares favorably with the S&P 500 earnings growth of 8.0%. On the revenue front, the sector seems to have performed badly considering the S&P 500 revenue growth of 4.2%.

The aerospace sector’s earnings are expected to grow at a clip of 4.4%, 8.9%, 5.4% and 2.2% for the third quarter 2014, fourth quarter 2014, first quarter 2015 and second quarter 2015. For the S&P 500, the bottom line will likely register year-over-year growth of 4.5%, 10.0%, 10.6% and 8.9% for the next four quarters. This puts the aerospace sector in a not-so-favorable light when compared to the broader markets, particularly going into 2015. This suggests some hard choices ahead.

For 2014 on the whole, the aerospace sector is expected to register bottom-line growth of 10.2% which will decline to 7.0% in 2015. The top line will likely see 0.8% and 1.6% growth in 2014 and 2015, respectively.

For further details on the earnings outlook for this sector and others, please see our weekly Earnings Outlook.

OPPORTUNITIES

Although sequestration casts a shadow of uncertainty on long-term funding for periods beyond fiscal 2015, if we are to pick the top defense stock it would be Pentagon’s prime contractor and the world’s largest defense company Lockheed Martin Corp. (LMT). The company reported a forecast-beating 4.5% rise in second-quarter 2014 earnings per share, backed by strong operational performance. The company raised its 2014 earnings guidance, reflecting lower pension costs and an improved outlook for its space unit.

Given the vital role played by satellites in the military space, Lockheed Martin is looking to bolster its satellite product coverage by increasingly investing in R&D and acquisitions.

Although Lockheed has run up against F-35 glitches lately, its F-35 program will definitely trigger significant top-line generation for the company. The Pentagon in its budget for fiscal 2015 (beginning Oct 1) requested $8.3 billion for 34 of the aircraft, including 26 F-35As, 6 F-35Bs and 2 F-35Cs.

Another defense giant, Northrop Grumman Corp. (NOC), has delivered a year-to-date return of about 7.34%, outperforming the S&P return of 4.62%. With a market cap of $25.58 billion, the defense major has a one-year return of 28.83%, higher than the S&P 500 return of 14.33%.

This Zacks Rank #2 (Buy) company reported higher profits in the second quarter despite missing analyst expectations. The company also raised its earnings guidance for the year, with international sales expected to reach 13% of total sales, up from 10% in 2013. The growth will likely come from unmanned aerial vehicles and cyber security work. It has delivered a positive earnings surprise of about 3.03% on an average over the last 4 quarters.

In a nutshell, a steady flow of contracts, which also include substantial international orders, a funded backlog of $35.55 billion as of Jun 30, 2014 the introduction of new products, and the commitment to return wealth to its shareholders make this stock attractive.

Since the start of 2014, there have been a number of share price gainers with General Dynamics (GD) witnessing the highest increase of around 23.72% buoyed by consistent contract wins and a stable second quarter 2014 performance. The Pentagon’s #3 contractor posted a 5.46% positive surprise over the last four quarters on an average. Yet, its revenues fell 4.6% in the second quarter, missing the Street expectation. Nonetheless, this Zacks Rank #2 (Buy) company recently increased its overall earnings outlook for the year to $7.40 to $7.45 per share from its earlier forecast of $7.05 to $7.10 per share. The company’s cost-cutting initiatives spurred profitability even as defense spending by the U.S. government remained low.

Another aerospace giant, The Boeing Co. (BA), carrying a Zacks Rank #2 (Buy), delivered a 17.30% positive surprise over the last four quarters on an average driven by solid operating performance and fueled by higher aircraft deliveries.

The company is also on the lookout for more international contracts to keep its top line rolling. Boeing is expanding its presence in cyber security, intelligence and surveillance and unmanned systems, where growth rates are higher than the overall defense budget.

Recently, Boeing delivered upbeat second quarter 2014 results backed by robust deliveries and soaring profits (up 45% year over year). Moreover, Boeing raised its full-year 2014 earnings outlook.

Another Zacks Ranked #2 (Buy) diversified U.S. conglomerate, Textron Inc. (TXT), reported better-than-expected second quarter 2014 earnings buoyed by higher contribution from most of its business segments. The Beechcraft acquisition also acted as a catalyst to the company’s quarterly performance. Textron reaffirmed its 2014 earnings per share from continuing operations guidance, taking into consideration the Beechcraft acquisition.

The near-term prospects of Zacks Ranked #2 (Buy) company Alliant Techsystems Inc. (ATK) also look good. It has delivered a positive earnings surprise of 16.73% last quarter and 21.17% over the last four quarters. The company’s Sporting segment continues to play an important role in this out performance. An improved performance from the company’s Sporting Group (up 57.3% year over year) and Aerospace Group (up 8.4%) led to the revenue surge in its fiscal first quarter 2015. This was partially offset by lower contribution from the Defense Group (down 6.9%). Alliant’s decision to form two independent public companies with leadership in Outdoor Sports and Aerospace and Defense will allow it to focus more on the respective operations.

Other promising stocks in the U.S. aerospace and defense space with a Zacks Rank #1 (Strong Buy) currently include Curtiss-Wright Corp. (CW), Ducommun Inc. (DCO) and Spirit AeroSystems Holdings, Inc. (SPR). The Zacks Ranked #2 (Buy) stocks include TransDigm Group Inc. (TDG), Esterline Technologies Corp. (ESL), Teledyne Technologies Inc. (TDY) and Triumph Group, Inc. (TGI).

Good to Hold

Although the threat of sequestration still lurks over this defense major, negatively impacting the company’s second quarter 2014 sales, the Navy's largest shipbuilder Huntington Ingalls Industries Inc. (HII), a Zacks Rank #3 (Hold) stock, has surpassed our estimates by 26.20% on average in the last 4 quarters. The company seems to be more protected than other defense contractors from budget cuts as the U.S. defense department is expanding its fleet of submarines and destroyers and introducing a new version of aircraft carriers, particularly focused on the Asian-Pacific region.

During the second quarter, Huntington Ingalls also expanded its business with the UniversalPegasus International Holdings acquisition. The latter is a provider of engineering and project management services to the domestic and international energy markets. The deal marks Huntington Ingalls’ entry into the oil and gas market.

In the electric/military group, our preferred name is of course Raytheon Company (RTN). Driven by operational improvements and capital deployment actions, the earnings surprise over the last four quarters was a positive 6.38%.

Although budget sequestration has weighed upon defense contractors, this Zacks Rank #3 (Hold) company appears to have clinched high-value contracts during the second quarter. New bookings in the second quarter were $6.8 billion versus $5.3 billion in the year-ago period. Book-to-bill was 1.19x in the quarter. Total backlog at the end of the quarter was $33.0 billion (up 1.8% year over year) while funded backlog was $23.6 billion (up about 6.4%).

Foreign military contracts continue to be the vital growth driver at Raytheon. International sales are expected to rise in the mid single digit, contributing 30% of projected 2014 sales.

Other stocks in the U.S. aerospace and defense space with a Zacks Rank #3 include:  Air Industries Group (AIRI), Airbus Group N.V. (EADSY), Embraer S.A. (ERJ), Leidos Holdings, Inc. (LDOS), Wesco Aircraft Holdings, Inc. (WAIR), AeroVironment, Inc. (AVAV), American Science & Engineering Inc. (ASEI), Astronics Corporation (ATRO), B/E Aerospace Inc. (BEAV), CAE Inc. (CAE), CPI Aerostructures Inc. (CVU), GenCorp Inc. (GY), Hexcel Corp. (HXL), Kratos Defense & Security Solutions, Inc. (KTOS), Orbital Sciences Corp. (ORB), Rockwell Collins Inc. (COL), FLIR Systems, Inc. (FLIR), LMI Aerospace Inc. (LMIA), Arotech Corporation (ARTX) and L-3 Communications Holdings Inc. (LLL).

WEAKNESSES

We remain apprehensive on the Zacks Ranked #4 (Sell) company AAR Corp. (AIR). This aerospace and defense products and services supplier continues to face pressure in airlift and MRO services.

Other Zacks Ranked #4 (Sell) stocks like Engility Holdings, Inc. (EGL), HEICO Corporation (HEI), Moog Inc. (MOG.A) and Rolls Royce Holdings plc (RYCEY) are also to be avoided.

In addition, we are skeptical of these Zacks Ranked #5 (Strong Sell) stocks – Erickson Inc. (EAC), Exelis Inc. (XLS) and API Technologies Corp. (ATNY).

Our Take

The aerospace & defense industry has been a keystone of the U.S. economy for decades and has provided well paying jobs for a variety of skill levels. The U.S. aerospace industry continues to contribute significantly to the country's economy and provides capabilities vital for national security.

However, the industry's position is now challenged by global competition, changes in technology, national and worldwide economic conditions and global policies affecting defense, civilian and commercial aviation.

On the whole, budget austerities remain an overhang on the military sector. The companies that have little diversification outside the U.S. are highly susceptible to spending cuts from sequestration. On the other hand, those with an international order book would find it less difficult to combat sequestration.

With careful management and prudent spending the sector is expected to weather the anemic defense budget environment. Though revenues were admittedly soft in the second quarter, it enjoyed an overall robust earnings season on the back of technological progress, accretive acquisitions and cost-cutting efforts. This keeps us for the most part positive on the sector.

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