Aerospace and Defense Industry Outlook - August 2013
Overview
The aerospace and defense industry found its largest base in the
U.S. with a military budget fittingly impressive. The country's
global leadership position requires it to maintain the capacity to
respond to the ever-changing national security environment.
In Apr 2013, the Obama administration proposed a defense budget of
$526.6 billion for FY14, down $0.9 billion from the FY13 annualized
continuing resolution level of $527.5 billion. However, the FY14
request does not yet include a detailed budget for Overseas
Contingency Operations ("OCO"), which is essentially
government-speak for foreign wars and war on terror operations. The
government is yet to release the OCO budget.
The budget calls for the termination of a few programs which
include C-17 Airlifter, F-22 stealth fighter, Future Combat
Systems, Multiple Kill Vehicle, Kinetic Energy Interceptor,
Airborne Laser, Combat search and rescue helicopter and
Presidential helicopter.
Budget Issues - the Sequester
The budget sequester that went into effect at the start of Mar 2013
and that has a direct bearing on the U.S. government's defense
spending is a function of the country's fiscal and economic
challenges.
Per a media report released in June this year, the government has
provided details of $37 billion of sequestration cuts to occur by
Sep 30, 2013. These cuts will not spare any of the defense majors
from Lockheed Martin Corp. (LMT) to Huntington Ingalls Industries
Inc. (HII).
The Pentagon faces another $52 billion in reductions from planned
spending for the next fiscal year, if Congress and President Barack
Obama don’t reach a consensus on reducing the U.S. budget
deficit.
Offsetting the Sequestration Effect
Sequestration will cut some $1 trillion from the defense budget
over the next decade, according to The Washington Free Beacon. Yet,
the aerospace and defense industry is holding up well this year
thanks to technological innovations, big contracts, acquisitions
and growing commercial demand.
Since the domestic aerospace and defense sector is facing budget
cuts and a constrained spending environment, the industry is
looking for growth from international orders. Additionally, a
number of new emerging markets as well as developed 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.
Moreover, these defense behemoths have diversified their businesses
to counter the effect of the sequester. Also, the complex military
programs being awarded to these companies much before the
across-the-board spending cuts came into force have somewhat
diluted the sequester impact.
Zacks 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
industries with Zacks Industry Rank of #88 and lower is 'Positive,'
between #89 and #176 is 'Neutral' and #177 and higher is
'Negative.' Zacks Industry Rank for the Aerospace industry is at
#69 out of 260 industries, which puts it in the Positive zone.
Please note that the Zacks Rank for stocks, which is at the core of
our Industry Outlook, has an impressive track record going back
years, verified by outside auditors, to foretell stock prices,
particularly over the short term (1 to 3 months).
Five of the nine companies in our coverage has a Zacks Rank #2
(Buy). While 3 carry a Zacks Rank #3 (Hold), one holds a Zacks Rank
#5 (Strong Sell).
European Aeronautic Defence and Space Company EADS N.V. (EADSY),
General Dynamics Corp. (GD), Huntington Ingalls Industries,
Lockheed Martin and Northrop Grumman Corp. (NOC) carry a Zacks Rank
#2 (Buy). While The Boeing Company (BA), Erickson Air-Crane
Incorporated (EAC) and Wesco Aircraft Holdings, Inc. (WAIR) carry
Zacks Rank #3 (Hold), Embraer SA (ERJ) carries a Zacks Rank #5
(Strong Sell).
Earnings Review and Outlook
The second-quarter earnings season has been a testament to the
bullish trend in the defense sphere, defying sequestration and
budget cut woes. The earnings results of all the defense companies
in our universe except one surpassed the Zacks Consensus
Estimate.
The highest positive surprise of 43 cents came from Lockheed Martin
while the lowest surprise of 2 cents coming from Textron Inc.
(TXT). Embraer SA missed the Zacks Consensus Estimate by 23%.
As per our data, as of Aug 1, 2013, the top and bottom line
earnings beat ratio was 87.5% and 75%, respectively as compared to
49.9% and 66.7%, respectively, for S&P 500 companies.
For a detailed look at the earnings outlook for this sector and
others, please read our weekly Earnings Trends reports.
The table below provides an outlook for the defense companies in
our universe:
The Gainers
From Mar 1, 2013 to date, there have been a number of share price
gainers with Alliant Techsystems Inc. (ATK) witnessing the highest
increase of 55.80% while Textron gaining 1.16%.
Alliant Techsystems
Alliant Techsystems with a Zacks Rank #1 (Strong Buy) witnessed a
positive earnings surprise of 16.67% this quarter and 15.68% over
the last four quarters. Strong results reflect increased profits,
lower interest expense, a lower tax rate and a decline in the share
count.
The company uses its cash in the best possible manner. Recently,
the company acquired Caliber Company, the parent company of Savage
Sports Corporation. The acquisition gives the company an
opportunity to bolster its leadership position in sporting and
security ammunition and accessories into the long guns market.
Apart from the company’s cash deployment strategy, a continuous
in-flow of contracts and an order backlog of $1.4 billion make it a
Strong Buy.
Raytheon Company
Driven by operational improvements and capital deployment actions,
the earnings surprise this quarter for Raytheon Company (RTN) was a
positive 26.15%. Surprise over the last four quarters was a
positive 22.15%. Beginning Mar 1, 2013, the company’s share price
has risen approximately 43%. Raytheon sports a Zacks Rank #1
(Strong Buy).
Though the third quarter 2013 and full year 2013 estimates in the
table above depict a year-over-year decline, Raytheon looks good
with continuous in-flow of contracts, introduction of new products,
completion of flight test series, consolidation and earnings beat
to boot.
As of Jun 30, 2013, the company had a funded backlog of $22.2
billion that would convert into revenues in the near term. In
addition, the strong cash position, consistent dividend payment and
repurchase of shares make the stock look attractive. Indeed, the
company’s strong cash position of $2.5 billion has been helping it
to acquire other firms. In June this year, the company acquired
Visual Analytics Inc. that will help the company in meeting the
data analytics, data visualization and information sharing needs of
its customers.
Northrop Grumman
From Mar 1, 2013 to date, the company’s share price has boosted
46.5%. It has delivered a positive earnings surprise of 20.59% this
quarter driven by a lower share count and strong operating
performance. The earnings beat over the last four quarters comes to
13.22%.
A steady flow of contracts which also include international orders,
a funded backlog of $23.2 billion, introduction of new products,
and the tendency of returning wealth to its shareholders drive this
Zacks Rank #2 (Buy) stock.
Lockheed Martin
Lockheed Martin, the foremost defense prime, experienced its share
price rise 42.2% since Mar 1, 2013. The positive surprise was
19.46% in this quarter and 15.44% in the last four quarters.
Lockheed Martin with a Zacks Rank #2 (Buy) has a strong liquidity
position and utilizes the cash in the best possible manner via
dividends and share repurchases. Loaded with contracts, Lockheed
Martin is building three models of the F-35 for the U.S. military
and eight international partner countries including Britain,
Australia, Canada, Norway, Turkey, Italy, Denmark and the
Netherlands. Israel and Japan have also ordered the jet. Lockheed
Martin’s F-35 program accounts for approximately 15% of the
company’s revenue, which is expected to go up in the coming
years.
Huntington Ingalls Industries
This company carrying a Zacks Rank #2 (Buy) ended the quarter with
a 21.74% positive surprise driven by solid program execution at
Ingalls Shipbuilding and Newport News Shipbuilding while it posted
a 7.71% positive surprise over the last four quarters on
average. Beginning Mar 1, 2013, the company saw its share
price soar 35.5%.
Good to Hold
The Boeing Company
Though the company carries a Zacks Rank #3 (Hold), we note that it
has surpassed the Zacks Consensus Estimate by 5.70% in this quarter
driven by solid operating performance fueled by higher aircraft
deliveries and lower 787 Dreamliner production costs. Over the last
four quarters, the company experienced a 12.87% positive surprise
on an average.
Despite various technical issues at its Commercial Airplane
Division, the company’s share price seems to be shock resistant,
rising 38.70% from Mar 1, 2013. Backlog and deliveries are also
robust. Total Defense, Space & Security backlog was $51.5
billion as of Jun 30, 2013.
Losers
Embraer SA
The company showed a negative earnings surprise of 23.08% this
quarter reflecting lower commercial aviation deliveries. It
experienced a 36.12% negative surprise over the last four quarters
on an average. The company’s share price has also dipped 1.04%
beginning Mar 1, 2013.
The company has a Zacks Rank #5 (Strong Sell) and is recommended to
be avoided for the time being.
Pros and Cons
Undeterred by defense budget cuts, the big defense operators are
expanding their operations through acquisitions. Moreover, in order
to counter the domestic headwinds, these players are looking for
growth from international orders and are busy restructuring their
businesses. Also, they are keeping themselves abreast in the
technological front with new products countering fresh
competition.
The broad growth and development of the aerospace and defense
industry is tied to the defense budgets of different nations around
the globe, besides the U.S. The U.S. defense department has reduced
the defense budget significantly. These cutbacks will impact the
big contractors, as the lion's share of their revenues comes from
domestic defense spending. Moreover, with the majority of revenue
coming from government contracts, the industry could be adversely
affected by the cancellation and delay of major government
contracts. Again, with more and more acquisitions being made by the
defense players, there is always the risk of completion,
integration, and financing of these deals.
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, on the flip side, 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.
Moreover, any delay in the execution of orders would lead to an
imbalance between the cost and revenue structure. This would not
only hurt profitability but also lead to delays and even
cancellations of orders and/or programs.
Sequestration still remains an overhang both in the civil and
military sectors. 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 outwit sequestration.
Keeping in mind the solid earnings season, technological progress,
acquisition benefits and cost-cutting efforts of individual
companies, we have an overall bullish outlook for the sector.
ALLIANT TECHSYS (ATK): Free Stock Analysis Report
BOEING CO (BA): Free Stock Analysis Report
ERICKSON AIR-CR (EAC): Free Stock Analysis Report
EMBRAER AIR-ADR (ERJ): Free Stock Analysis Report
GENL DYNAMICS (GD): Free Stock Analysis Report
HUNTINGTON INGL (HII): Free Stock Analysis Report
LOCKHEED MARTIN (LMT): Free Stock Analysis Report
NORTHROP GRUMMN (NOC): Free Stock Analysis Report
RAYTHEON CO (RTN): Free Stock Analysis Report
TEXTRON INC (TXT): Free Stock Analysis Report
WESCO AIRCRAFT (WAIR): Free Stock Analysis Report
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