Aerospace & Defense Industry Outlook - July 2017

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Escalating geo-political tensions, international terrorist acts threatening the security of nations and intra-national conflicts giving rise to many civil wars have that created an opportunity for defense contractors. This, in turn, has given a boost to the outlook for the aerospace and defense industry.

In particular, a notable increase in the U.S. defense budget in the era of President Trump and rising defense spending by other major regional powers such as Japan and India have bolstered investors' optimism in this industry's ascension.

Impressively, stocks in the Zacks Aerospace sector (a stand-alone sector) rallied 29.1% in the last year, significantly outperforming the S&P 500 index's 13.6% gain. With the majority of macroeconomic factors favoring this industry, such outperformance can be expected in the days ahead as well.

U.S. Defense Scenario

Given its enormity in terms of economic growth, the U.S. comprises by far the largest market for defense equipment, systems and services in the world.

Primarily, factors like a growing international market for weaponries with more developing nations expanding their defense spending, the advent of innovative technologies in warfare and their increasing application as well as increased demand for cost-efficient production are driving revenue growth in U.S. Aerospace.

In addition, macroeconomic statistics like the nation's unemployment rate falling to a record 16-year low of 4.3% in May, a more-or-less stabilized oil price in the last three months, and a 1.6% annual rise in the consumer price index (CPI) for all items have been favoring the economy's growth. Evidently, the U.S. economy expanded an annualized 1.4% in the first quarter of 2017.

Naturally, these have set the stage for more upside in the aerospace-defense industry, since a strong economy can better support defense funding. With the economy projected to come up with GDP growth of 2.6% in the second quarter, we may expect the industry to grow at an accelerated pace.

However, a decline in skilled workforce and increasing competition with emerging nations vigorously engaged in unveiling their own defense equipment continue to pose as challenges to this industry. Nevertheless, its non-cyclical feature has always helped the industry to overcome all the oddities and stay afloat.

Budget Updates

On Mar 16, 2017, President Trump unveiled the Pentagon's fiscal 2018 (FY 2018) budget proposal, reflecting a total increase of $54 billion over the current FY 2017 level. The proposed budget of $639 billion includes a base budget of $574 billion, reflecting a $52 billion increase over the FY 2017 budget level of $587 billion. This budget also includes $65 billion in funding for the Pentagon's overseas contingency operations (OCO) fund, higher than the FY 2017 level by $2 billion.

The FY 2018 budget proposal mainly addressed three agendas: focus on keeping Americans safe, keeping terrorists out of the country and putting violent offenders behind bars. Further, Trump offered another proposal to increase the current fiscal's defense budget by $30 billion - $24.9 billion in base budget and $5.1 billion in OCO.

More recently, the House passed a $696.5 billion defense policy bill for 2018 that exceeded the nation's statutory budget cap. If the Senate eventually approves all the aforementioned proposals, the major defense contractors will surely get a huge boost in revenues.

Zacks Industry Rank - Mixed Bag

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 industries is that, we put our X industries (all 265 of them) into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than 2 to 1. (To learn more visit: About Zacks Industry Rank .)

The Aerospace is one of the 16 broad Zacks sectors 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.

Aerospace/defense, with a Zacks Industry Rank #90, as well as electronics-military with a Zacks Industry Rank #46, remain in the top half. Also, aerospace/defense equipment with a Zacks Industry Rank #118 came in the top half.

Earnings Review and Outlook

Amid headwinds, the Aerospace sector held up well in the first quarter. The earnings beat ratio for the stocks in this space (percentage of companies coming up with positive surprises) was an impressive 80%, while the revenue beat ratio was 40%.

Going forward, the earnings picture for the second quarter of 2017 reveals a mixed bag. The sector's earnings are expected to improve a solid 59.9% in the second quarter, while revenues are expected to see a 0.8% decline (as of Jul 28, 2017). Margins for this sector are expected to rise 3% in the quarter. Notably, this sector is one out of the 11 of the 16 Zacks sectors that are expected to exhibit positive earnings growth this quarter.

Defense Stocks Worth Adding

Investors might keep a watch on the following defense biggies that have the financial strength to withstand headwinds and reflect an impressive earnings scorecard.

AeroVironment, Inc. (AVAV) has a long-term earnings growth projection of 15%. This stock registered positive earnings surprise of 31.31% in the prior quarter. Its fiscal 2018 earnings estimates moved up 12.5% in the last 60 days. AeroVironment currently sports a Zacks Rank #1 (Strong Buy).

The Boeing Company (BA) has a long-term earnings growth projection of 13%. This stock registered positive earnings surprises in all of the last four quarters, with an average beat of 13.67%. Its 2017 earnings estimates moved up 6.2% in the last 60 days. Boeing currently sports a Zacks Rank #2 (Buy). You can see the complete list of today's Zacks #1 Rank (Strong Buy) stocks here .

Huntington Ingalls Industries, Inc. (HII) has a long-term earnings growth projection of 15%. This stock registered positive earnings surprises in two of the last four quarters, with an average beat of 3.04%. Its 2017 earnings estimates have seen 1 upward movement in the last 60 days. Huntington Ingalls currently sports a Zacks Rank #2.

Summing Up

With the U.S. being the largest supplier of the world's most-advanced weaponries, emerging global security threats force allied nations to turn to it for defense aid as well as for buying state-of-the art ammunition. Naturally, the nation's aerospace and defense industry has been a direct beneficiary of this demand.

As no improvement can be expected any time soon in geopolitical uncertainty prevailing worldwide, this industry will likely continue to excel in the days ahead, as will its stocks.

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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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