The word "sequestration" had an ominous ring for the defense
industry in the year 2013. Nonetheless, the industry has emerged
relatively unscathed thanks 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.
Undeterred by defense budget cuts, the big defense operators are
expanding their operations through acquisitions and foreign orders.
They are also busy restructuring their businesses and keeping
themselves abreast of technology to counter 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. These have to some extent compensated
for lower defense spending at home. The U.S. defense department has
reduced the defense budget significantly. These cutbacks will
continue to impact the big contractors, as the lion's share of
their revenues still comes from domestic defense spending.
On the other hand, strong performance in the commercial aerospace
sector is being driven by growing demand for passenger air travel
worldwide and by accelerated replacement of obsolete aircraft with
more fuel-efficient models.
In Mar 2014, the Obama administration proposed a base defense
budget of $495.6 billion for FY15, which begins on October 1, down
$0.4 billion from the enacted FY14 budget of $496.0 billion.
For Overseas Contingency Operations (OCO), which is essentially
government-speak for foreign wars and war on terror operations, the
FY15 budget has $79 billion in it. The amount is equivalent to the
request for FY14. However, a formal budget for OCO is still
negotiable with the Congress and will be proposed once a decision
about the scope of the enduring U.S. presence in Afghanistan is
Additionally, in the FY15 budget proposal, there is a new
contingency fund: the Opportunity, Growth and Security Initiative.
The defense department set a budget proposal of $26.4 billion for
this fund, which could also be used for urgent military
requirements as well as high-priority systems upgrades and
This initiative also comprises additional funding for Joint Strike
Fighters and P-8 aircraft and more spending on the Army Blackhawk
program. Funding for military construction and base sustainment is
also expected to increase. Funding for this contingency initiative
will be compensated by mandatory spending reductions and tax
Again, for FY14, the $1.1 trillion Omnibus spending measure
President Obama signed into law was a big relief for the Pentagon.
The bill provides Pentagon with nearly $93 billion to buy weapons
and another $63 billion for research and development.
Offsetting the Sequestration Effect
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
8-year period from 2013 to 2021.Yet, the aerospace and defense
industry is holding up well in 2014 thanks to technological
innovations, big contracts, acquisitions and growing commercial
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 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, the defense majors have diversified their businesses to
counter the effect of the sequester. Also, complex military
programs already awarded to these companies much before the
across-the-board spending cuts came into force have somewhat
diluted the sequester impact.
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 259+ 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 #44 out of 259
industries, which puts it in a positive light. The
'aerospace/defense equipment' -- with a Zacks Industry Rank #87
also comes under the top 1/3rd. However, the 'electric-military'
lies in the bottom one-third of all Zacks industries, with a Zacks
Industry Rank #192.
Hence, the general outlook for the aerospace sector is on the whole
positive. Investors should however be a little weary of the bearish
Earnings Review and Outlook
The aerospace & defense sector posted an impressive performance
in 2013, braving issues like sequestration, budget cuts and
cancellation of big-ticket programs. In fact, in the year-end
quarter, all the defense companies in our universe, except one,
surpassed the Zacks Consensus Estimate.
The highest positive surprise of 85 cents was clocked by
) while the lowest surprise of 0.6% came from
General Dynamics Corp.
). On the contrary,
Wesco Aircraft Holdings, Inc.
) missed the Zacks Consensus Estimate by 6.9%.
The aerospace sector's earnings are expected to decline 5.1% in the
first quarter of 2014 compared with 20.0% growth in the last
quarter. However, the sector will likely witness 1.0% top-line
growth in the to-be-reported quarter as against a 0.1% fall in the
For 2014 on the whole, the sector is expected to register
bottom-line growth of 4.5% which will further rise to 10.5% in
2015. The top line will likely see 0.9% and 1.5% growth in 2014 and
For a detailed look at the earnings outlook for this sector and
others, please see our weekly
Although the threat from sequestration remains for periods beyond
fiscal 2015 and casts a shadow of uncertainty on long-term funding,
we would prefer
Huntington Ingalls Industries Inc.
), a Zacks Rank #1 (Strong Buy) stock, posting strong financial
results and surpassing our estimates by 34.7% on an average in the
last 4 quarters. This upside was driven by higher revenues from
surface combatants and the Legend-class NSS program.
Since the start of 2014, there have been a number of share price
gainers with General Dynamics witnessing the highest increase of
around 11.5% so far buoyed by consistent contract wins and a stable
fourth quarter performance. It posted a 7.5% positive surprise over
the last four quarters on an average.
With approximately $2.7 billion of free cash flow exiting 2013,
General Dynamics' solid financial position well cushions the
dividend payout. At the end of the fourth quarter 2013, its cash
and cash equivalents stood at $5.3 billion, reflecting an increase
of almost 61.0% from year-end 2012.
This Zacks Rank #2 (Buy) company recently boosted its quarterly
dividend by 10.7%, marking the 17th consecutive increase and
bringing the annualized payout to $2.48 per share.
Among the defense top players,
Northrop Grumman Corp.
) has delivered a year-to-date return of about 2.4%, outperforming
the S&P return of negative 1.4%. With a market cap of $25.29
billion, the defense major has a one-year return of 61.8%, higher
than the S&P 500 return of 14.3%.
This Zacks Rank #2 (Buy) company successfully beat the Zacks
Consensus Estimate on both the top and the bottom line in the
fourth quarter of 2013 and has a positive earnings surprise of
about 3.1% on an average over the last 4 quarters. The earnings
beat was attributable to a lower share count and strong operating
In a nutshell, a steady flow of contracts, which also include
substantial international orders, a funded backlog of $22.5 billion
as of Dec 31, 2013, the introduction of new products, and the
commitment to return wealth to its shareholders make this stock
The world's third largest commercial aircraft manufacturer, Embraer
SA's fourth-quarter earnings jumped 177.0% from the prior-year
quarter and beat the Zacks Consensus Estimate by 70.8%. This Zacks
Rank #2 (Buy) company's stellar performance was backed by strong
demand for its commercial and executive jets.
Embraer expects double-digit growth in the Defense & Security
segment for 2014 due to the continuous progress in the military
transport (KC-390) as well as the Border Monitoring system, Super
Tucano LAS program and satellite programs.
Now, in the electric/military group, our preferred name will be
). Driven by operational improvements and capital deployment
actions, the earnings surprise last quarter for Raytheon was a
positive 17.0%. Surprise over the last four quarters was a positive
Although budget sequestration has weighed upon defense contractors,
Raytheon appears to have clinched high-value contracts during the
fourth quarter. Orders were even stronger with a book-to-bill in
the quarter of 1.28x.
Foreign military contracts continue to be the vital growth driver
for Raytheon. International sales represented 27% of total revenues
in 2013, up 3% year over year. International sales are expected to
rise in the mid single digit, contributing 30% of projected 2014
Recently, this Zacks Rank #2 (Buy) defense prime boosted its annual
dividend by 10.0%, marking the 10th consecutive annual increase.
The company's share price has risen approximately 9.3% so far this
Investors can also consider another name in this electric/military
L-3 Communications Holdings Inc.
). The share price of L-3 Communications has been rising ever since
it reported strong fourth quarter 2013 results on Jan 30. This
Zacks Rank #2 (Buy) stock has delivered an average positive
earnings surprise of 4.8% over the past 4 quarters, keeping
investors' confidence intact. The consistently strong performance
was due to L-3 Communications' program execution capability,
cost-cutting initiatives and contribution from its international
and commercial businesses.
One may also capitalize on opportunities in a related business
sector that of aerospace and defense equipment providers. Our top
pick in this space is
). This company has set new records for revenue, bookings and
backlog in the fourth quarter 2013 accompanied with three
significant acquisitions in the second half of the year propelling
growth opportunities for the future.
Again, the near-term prospects of
Alliant Techsystems Inc.
) look good. It has delivered a positive earnings surprise of 43.5%
last quarter and 22.2% over the last four quarters. The company's
Sporting segment continues to play an important role in this out
performance. In the third quarter of fiscal 2014, the segment
recorded a considerable 78.2% year-over-year increase in sales.
This upside was primarily driven by the acquisitions of Bushnell
Group Holding Inc. and Caliber Company.
Other promising stocks in the U.S. aerospace and defense space with
a Zacks Rank #2 (Buy) currently include
B/E Aerospace Inc.
BAE Systems plc
TransDigm Group Inc.
Good to Hold
Lockheed Martin Corp.
), the foremost defense prime, experienced its share price rise
8.9% in the year-to-date period. The stock holds a Zacks Rank #3
Although the threat of sequestration still lurks over this defense
major, negatively impacting the company's 2013 sales, Lockheed
Martin seems to be on a wining spree in recent times. The defense
premier generated $15.4 billion in orders in the fourth quarter of
2013. Again, the healthy dividend yield and stable cash flow will
likely make the stock a defensive holding in the current market
Lockheed Martin's pricey F-35 program is expected to gain
significant traction in 2014 and 2015. Although the 2015 DoD
request for procurement of $90.4 billion is down from the 2014
request of $115.1 billion, it comprises $4.6 billion for 26 F-35
Joint Strike Fighters for 2015, and $31.7 billion for 238
additional Joint Strike Fighters over the next several years. This
will definitely trigger significant top-line generation for the
Another aerospace giant
The Boeing Co.
), carrying a Zacks Rank #3 (Hold), has surpassed the Zacks
Consensus Estimate by 18.2% in the past quarter driven by solid
operating performance fueled by higher aircraft deliveries. Over
the last four quarters, the company experienced a 14.6% positive
surprise on an average.
Backlog and deliveries are also robust. Total Defense, Space &
Security backlog was $67 billion as of Dec 31, 2013.
The aviation and military electronics maker
Rockwell Collins Inc.
), posted strong fiscal first quarter 2014 results backed by solid
contribution from its Commercial Systems and Government Systems
segments. The company delivered a positive earnings surprise in
three out of the last four quarters, with an average beat of 0.99%,
showing a somewhat stable operational performance.
We remain apprehensive on the Zacks Ranked #5 (Strong Sell) company
). This aerospace and defense products and services supplier
continues to face continued pressure in airlift and MRO services.
As a pointer, the company has lowered its top- and bottom-line
forecast for fiscal 2014.
Other Zacks Ranked #4 (Sell) stocks like
Kratos Defense & Security Solutions, Inc.
Rolls Royce Holdings plc
Triumph Group, Inc.
) are also to be avoided.
We are also skeptical of these Zacks Ranked #5 (Strong Sell) stocks
Leidos Holdings, Inc.
CPI Aerostructures Inc.
API Technologies Corp.
FLIR Systems, Inc.
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.
On the whole, budget austerities still 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 outwit sequestration.
Admittedly, the sector enjoyed a solid earnings season,
technological progress, acquisition benefits and cost-cutting
efforts from individual companies. This keeps us generally positive
on the sector for the time being.
AAR CORP (AIR): Free Stock Analysis Report
ALLIANT TECHSYS (ATK): Free Stock Analysis
API TECH CORP (ATNY): Free Stock Analysis
ASTRONICS CORP (ATRO): Free Stock Analysis
AEROVIRONMENT (AVAV): Free Stock Analysis
BOEING CO (BA): Free Stock Analysis Report
BAE SYSTEMS-ADR (BAESY): Get Free Report
B/E AEROSPACE (BEAV): Free Stock Analysis
ROCKWELL COLLIN (COL): Free Stock Analysis
CPI AEROSTRUCTR (CVU): Free Stock Analysis
CURTISS WRIGHT (CW): Free Stock Analysis Report
EMBRAER AIR-ADR (ERJ): Free Stock Analysis
FLIR SYSTEMS (FLIR): Free Stock Analysis Report
GENL DYNAMICS (GD): Free Stock Analysis Report
HEICO CORP (HEI): Free Stock Analysis Report
HUNTINGTON INGL (HII): Free Stock Analysis
KRATOS DEFENSE (KTOS): Free Stock Analysis
LEIDOS HOLDINGS (LDOS): Free Stock Analysis
L-3 COMM HLDGS (LLL): Free Stock Analysis
NORTHROP GRUMMN (NOC): Free Stock Analysis
RAYTHEON CO (RTN): Free Stock Analysis Report
ROLLS ROYCE PLC (RYCEY): Get Free Report
TRANSDIGM GROUP (TDG): Free Stock Analysis
TRIUMPH GRP INC (TGI): Free Stock Analysis
WESCO AIRCRAFT (WAIR): Free Stock Analysis
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