Aerospace-Defense Equipment Outlook: Budget a Boon Amid Trade War

The latest budget proposals from Pentagon, reflecting hawkish spending provisions for the U.S. Department of Defense (DoD), along with rapidly rising global air traffic boosting aircraft production rates should keep the U.S. Aerospace-Defense Equipment stocks' momentum alive. However, increasing competition with nations like China that are vigorously engaged in unveiling their aerospace and defense equipment poses a threat for the near-term growth prospects of this space.

While rising competition has frequently prompted the industry bigwigs to expand their product lines through small and medium acquisitions, last year we saw a handful of big bang mergers in the industry as cost reduction initiatives and increased control over production procedures gained precedence. For instance, in September 2017, United Technologies agreed to take over Rockwell Collins for $30 billion, a deal aimed at creating one of the world's largest aircraft-equipment manufacturers.

However, the recent import tariffs imposed on aluminum and steel by the Trump administration have emerged as a major headwind as these are the basic raw materials required for the manufacturing of vital aerospace and defense equipment. With declining operational aluminum smelters in the country, the United States largely depends on foreign countries for aluminum supply and such a regressive tariff increases the possibility of a rise in costs and disruption of supply chains. Nevertheless, increased worldwide spending in commercial aerospace and defense should maintain the decent rally of the stocks.

Industry Outperforms Market

Looking at shareholder returns over the past year, it appears that the current U.S. government's adoption of restrictive trade policies, which initially jolted the entire stock market, hardly impacted investors' confidence in the industry. Moreover, the United States - being the largest digitally advanced country - is enhancing its electronic warfare, C4ISR (Command, Control, Communication, Computers, Intelligence, Surveillance and Reconnaissance) and cyber security measures following rampant cyber-attacks that affected a number of countries last year. This should provide further impetus to the stocks in this space, especially those providing defense electronics. Further, emerging countries have increased their defense spending in recent times. This should be encouraging for investors in the aerospace and defense equipment space.

The Zacks Aerospace-Defense Equipment Industry , which is a 25-stock group within the broader Zacks Aerospace Sector , has outperformed the S&P 500 but came below its own sector over the past year.

While the stocks in this industry have collectively rallied 23.6%, the Zacks S&P 500 Composite and Zacks Oils-Energy Sector have gained 15.8% and 25%, respectively.

One-Year Price Performance

Optimistic Valuation for Aerospace-Defense EquipmentStocks

Impressively, even after delivering an outperformance over the past year, the valuation for this industry still looks cheap, when compared to that of the market. One might get a good sense of the industry's relative valuation by looking at its enterprise-to-sales ratio (EV/Sales), which is an appropriate multiple for valuing investment-oriented stocks like aerospace-defense equipment.

This ratio essentially measures a stock's current market value, including its debt, relative to its sales value.

The industry currently has a trailing 12-month EV/Sales ratio of 2.31, which is near the median of the multiple's level over the past year. When compared with the highest level of 2.35 and the lowest level of 2.04 over that period, there is still room for an upside.

The space also looks inexpensive when compared with the market at large, as the trailing 12-month EV/Sales ratio for the S&P 500 is 3.12 and the median level is 2.95.

Enterprise Value-Sales Ratio (TTM)

However,a comparison of the group's EV/Sales ratio with that of its broader sector ensures that the group is trading at a premium. The Zacks Aerospace Sector's trailing 12-month EV/Sales ratio of 1.51 and the median level of 1.44 for the same period are way below the Zacks Aerospace-Defense Equipment Industry's respective ratios.

While this comparison might initially seem a bit disappointing, we should keep in mind that a higher EV/Sales ratio signals that the future sales prospects of the industry are attractive, when compared to that of the sector. In fact, since the industry's EV/Sales ratio came in lower than that of the broader market, we should be optimistic that there's still enough room left for the aerospace-defense equipment stocks' sale growth in the days ahead.

Enterprise Value-Sales Ratio (TTM)

Earnings Outlook: A Disappointing Picture

Rising global trade activity has been boosting commercial aerospace, while escalating geopolitical uncertainty has been fueling defense spending worldwide. These should cumulatively allow stocks in the aerospace defense equipment space to continue generating positive shareholder returns in the near future.

But what really matters to investors is whether this group has the potential to perform better than the broader market in the quarters ahead. While the above ratio analysis shows that there is a solid value-oriented path ahead, one should not really consider the current price levels as good entry points unless there are convincing reasons to predict a rebound in the near term.

One reliable measure that can help investors understand the industry's prospects for a solid price performance is the earnings outlook for its member companies. Empirical research shows that a company's earnings outlook significantly influences the performance of its stock.

One could get a good sense of a company's earnings outlook by comparing the consensus earnings expectation for the current financial year with the last year's reported number, but an effective measure could be the magnitude and direction of the recent change in earnings estimates.

Unfortunately, neither the consensus earnings estimate for the Zacks Aerospace-Defense Equipment industry of $4.62 per share nor the trend in earnings estimate revisions indicates year-over-year improvement.

Price and Consensus: Zacks Aerospace-Defense Equipment industry

Zacks Industry Rank Indicates Growth Prospects

The group's Zacks Industry Rank , which is basically the average of the Zacks Rank of all the member stocks, indicates continued underperformance in the near term.

The Zacks Aerospace-Defense Equipment industry currently carries a Zacks Industry Rank #114, which places it at the top 45% of more than 250 Zacks industries. Our research shows that the top 50% of the Zacks-ranked industries outperforms the bottom 50% by a factor of more than 2 to 1.

Solar Stocks Promise Long-Term Growth

While the near-term prospects might not look very welcoming for investors, the long-term (3-5 years) EPS growth estimate for the Zacks Solar industry appears promising. The group's mean estimate of long-term EPS growth rate has been increasing since beginning of 2018 to reach the current level of 12.5%. This compares with 9.7% for the Zacks S&P 500 composite.

Mean Estimate of Long-Term EPS Growth Rate

In fact, the basis of this long-term EPS growth could be the recovery in gross profit that the aerospace-defense equipment stocks have been witnessing since the beginning of 2016.

Bottom Line

The aerospace-defense equipment industry needs a highly skilled and productive workforce to maintain stability. Yet, lately, the industry is facing impending retirements, witnessing a relatively high attrition rate for new employees and a greater proportion of older workers. Per the Aviation Week & Space Technology 2017 Aerospace & Defense Workforce Study, approximately 60% of employees in this industry are over the age of 45 versus 44% in the overall U.S. workforce. This should be addressed immediately to keep the momentum of the industry going.

This workforce issue and the impact of the recent tariffs might mar the industry's growth prospects to some extent in the near term. However, given its favorable industry rank and price performance history, investors may bet on a few stocks in this space that exhibit a strong earnings outlook, taking advantage of the optimistic valuation trend.

Considering this space's long-term growth prospects, below we have mentioned three aerospace-defense equipment stocks that have a strong earnings outlook. These stocks have a favorable Zacks Rank #1 (Strong Buy) or Zacks Rank #2 (Buy) and have been witnessing positive earnings estimate revisions. You can see the complete list of today's Zacks #1 Rank stocks here .

Aerojet Rocketdyne Holdings, Inc. (AJRD): The stock of this Sacramento, CA-based propulsion systems manufacturer has gained 24.5% over the past year. The Zacks Consensus Estimate for the current fiscal-year EPS reflects an improvement of 5.2% over the last 60 days. It sports a Zacks Rank #1.

Price and Consensus: AJRD

Heico Corporation (HEI): The consensus EPS estimate for this Florida-based jet engine and aircraft component replacement parts manufacturer moved 1.1% higher for the current year over the last 60 days. The stock has rallied 51.4% over the past year. It carries a Zacks Rank #2.

Price and Consensus: HEI

Raytheon Company (RTN): The stock of this Massachusetts-based missile and radar manufacturer has improved 13.6% over the past year. The consensus EPS estimate for the current year moved up 0.3% over the last 60 days. It holds a Zacks Rank #2.

Price and Consensus: RTN

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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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