4 Defense Stocks Poised for a Q3 Earnings Beat

The picture is a little depressing for the aerospace and defense sector as it steps into the third quarter earnings season next week.

Economic growth is expected to have suffered in the third quarter of the year as the Atlanta Fed's real-time Q3 GDP growth estimate is currently tracking to +1.1%. Although the figure is up from the earlier forecast of 0.9%, it is quite a drop from the 3.9% growth realized in the prior quarter. Stocks have fallen sharply as the S&P 500 plunged 12% between Jul 20 and Aug 25 in the first stock market correction in four years.

Growth remained challenged for most of the quarter thanks to a strong dollar and weak energy prices. Moreover, the persistent slowdown in China deepened global economic woes. It is a sign that cracks are appearing in the economy in a year when the U.S. was reasserting itself as the global growth leader.

A stronger dollar could have an adverse impact on foreign military sales. Second-quarter 2015 results from United Technology ( UTX ) showed a significant negative impact from the China weakness and a strong dollar.

Overall, the picture is somewhat still gloomy as the aerospace sector's earnings are expected to decline 7.4% in the third quarter, though slightly better than Q2. The sector is expected to register top-line growth of 1% (4.6% growth in Q2) while margins are projected to move south by 0.6% (down 1.05% in Q2).

Mercurial Planet: a Defense Driver

In spite of uncertainties, the U.S. defense sector has held up well given the elevated geopolitical risk and strong commercial sales. This appears to be fueling support in Washington for an increase in fiscal 2016 defense spending above sequestration caps.

A politically unstable planet despite tottering economies has led to various nations stepping up their defense capabilities. The primary driver for these defense firms was the success they tasted in the 'rest of the world'. Countries allied to U.S. policy are spending substantially on sophisticated artillery to wage the war against terror and sectarian forces. The crisis has been acutely felt with the meteoric rise of the brutal jihadist group, Islamic State of Iraq and Syria (ISIS), in the Middle East, a situation that President Obama has coined "the network of death."

Capitalizing on this opportunity, the big U.S. defense operators are expanding their operations through acquisitions and collaborations, to meet the demand for rising foreign orders. Foreign sales have thus become a key revenue booster.

Budget Picture

Coming to budgetary issues, funding for the Department of Defense (DoD) for fiscal year 2016 is uncertain as President Obama and the GOP continue to fight over the federal budget. The major bone of contention is the multibillion-dollar Overseas Contingency Operations fund.

Having said that, the wind is definitely in favor of boosts to the defense budget, as the blood-smeared headlines from Syria, Russia, Ukraine, the Middle East, Iran and ISIS are increasingly difficult to ignore.

President Obama's fiscal 2016 budget proposal, unveiled on Feb 2, 2015, called for $534.3 billion to be allocated for the Department of Defense's base budget and $50.9 billion in war funds, a total of $585.3 billion. The base budget proposal is about $36 billion more than what sequestration would allow and over the FY2015 enacted budget of $496.1 billion.

In spite of the economic woes, the case for investing in defense stocks looks good in the light of the above arguments. Consequently, it is a profitable strategy to zero in on a handful of defense names that are poised to beat earnings estimates this quarter.

How to Pick?

Picking the right stock for your portfolio could appear to be a daunting task given the wide range of companies in the aerospace and defense space. One way to confine the list of choices during this earnings season is by looking at stocks that have a solid Zacks Rank accompanied by a favorable Earnings ESP . The combination of a favorable Zacks Rank - Zacks Rank #1 (Strong Buy), #2 (Buy) or #3 (Hold) - and a positive Earnings ESP is usually an indication of an earnings beat.

Earnings ESP is our proprietary methodology for determining which stocks have the best chance to pull a surprise in their next earnings announcement. It shows the percentage difference between the Most Accurate estimate and the Zacks Consensus Estimate.

Our research shows that for stocks with this combination, the chance of a positive earnings surprise is as high as 70%.

For investors seeking to apply this strategy to their portfolio, we have highlighted three defense stocks that may stand out this season.

General Dynamics Corp. ( GD )

General Dynamics' revenues are derived from a broad portfolio of products and services that help to keep the overall growth momentum steady. With the FY16 defense budget proposal laying emphasis on space systems, upgrading technologies, and nuclear and missile defense, General Dynamics stands to gain immense traction. General Dynamics − the maker of Gulfstream jets, tanks as well as war ships − is one of the only two contractors in the world equipped to build nuclear-powered submarines.

For the upcoming release, General Dynamics has an earnings ESP of +4.76% and a Zacks Rank #3. The company is set to report third-quarter results on Oct 28 before the opening bell. The company has a long-term earnings growth expectation of 8.55% and a forward P/E of 15.81.

Northrop Grumman Corp. ( NOC )

With rising security threats, the defense industry's increasing emphasis on high-tech intelligence equipment can be well traced to Northrop Grumman's timely focus on intelligence, surveillance and reconnaissance ("ISR") systems, advanced electronics and software development technologies. It is the proud owner of the popular Global Hawk, an unmanned system with the ability to transform itself into an operational weapons system when required. Northrop also boasts products like the E-2D Advanced Hawkeye, which provides 360-degree surveillance at all times.

This $32.57-billion market-cap, defense Zacks Ranked #2 company posted an average earnings surprise of 3.23% in the trailing four quarters. The company has a long-term earnings growth expectation of 7.32%. The company has a P/E (F1) of 17.87 along with an earnings ESP of +4.07%. The company is expected to report third-quarter 2015 results before the opening bell on Oct 28.

Boeing ( BA )

With a market cap of $91.20 billion, Boeing is the largest aircraft manufacturer in the world in terms of revenue, orders and deliveries, and one of the largest aerospace and defense contractors. It has already reported strong third-quarter as well as nine-month 2015 delivery numbers. The company delivered 580 commercial jetliners so far this year, increasing 9.8% year over year and beating its archrival Airbus. Demand for its commercial airplanes is on the rise due to a steady improvement in passenger and freight traffic.

The company has a long-term earnings growth expectation of 11.35% and a forward P/E of 16.70.

Boeing has a Zacks Rank #2 along with an earnings ESP +0.91%. The company is expected to report third-quarter 2015 results on Oct 21.

Lockheed Martin Corp. ( LMT )

Last but definitely not the least is the nation's leading defense contractor, Lockheed Martin. The company is all set to become an even bigger aerospace powerhouse with the proposed Sikorsky acquisition. The company has a platform-centric focus that guarantees a steady inflow of follow-on orders from a leveraged presence in the Army, Air Force, Navy and IT programs. With a market cap of $64.64 billion, the company has a long-term earnings growth expectation of 7.63% and a forward P/E of 18.34.

For the upcoming release, Lockheed Martin has an earnings ESP of +0.74% and a Zacks Rank #3. The company is set to report third quarter results on Oct 20 before the opening bell.

Bottom Line

Although a stronger dollar and budget austerity played spoilsport, we believe these four stocks are good picks for this earnings season considering their cost-cutting measures, stock buybacks and earnings gains from overseas businesses.

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GENL DYNAMICS (GD): Free Stock Analysis Report

NORTHROP GRUMMN (NOC): Free Stock Analysis Report

BOEING CO (BA): Free Stock Analysis Report

LOCKHEED MARTIN (LMT): Free Stock Analysis Report

UTD TECHS CORP (UTX): Free Stock Analysis Report

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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