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Can Defense Sector Cross Hurdles on Its Path to Growth?

The U.S. has been the world's largest defense consumer since World War II. Iraq and Afghanistan wars in the past have given a boost to spending on weaponry and armed forces, pushing the U.S. defense market to historic heights. However, the winding down of these wars and severe pressure to lower the national debt burden following the country's major financial distress since the Great Depression had cast a long shadow over the U.S. defense budget.

In fact, continued budget cuts by the U.S. Department of Defense (DoD) took its toll on the U.S. aerospace and defense industry in the past couple of years. Although the current macroeconomic factors and President Donald Trump's promise of spending "bigly" are in favor of the nation's economic growth, rising rate hikes and an ever-strengthening U.S. dollar have instilled concerns that this growth might be short-lived. In certain times, the U.S. government might not be able to fulfill its promise of spending amply on defense companies.

Various regulations imposed on international trade of defense equipment remain significant barriers to this sector's growth. Moreover, "disproportionate" cuts to modernization and research and development funding could act as major impediments to defense players.

Below we discuss the headwinds that could weigh on the aerospace and defense sector in the near term.

Market Pricing Scenario : There is no reason to doubt that the Trump administration's pledge to substantially ramp up defense spending has given a boost to the U.S. aerospace and defense industry. However, the aerospace sector has hardly been cheap after Trump took over. In fact, over the last five years, the sector traded as high as 18.7x forward 12-month earnings estimates and as low as 10.6x. It is currently trading at 18.2x forward 12-month EPS estimates toward the high-end of this five-year range and also higher than the S&P 500 index's 17.7x forward 12-month EPS estimates.

Also, the company's Price/Book-Value ratio of 7.92 was higher than that of the market's ratio of 3.54 over the last 5 years. This indicates that the aerospace sector is already overvalued when compared to market value and any further upside is unlikely.

Regulatory Impediments : The Aerospace & Defense industry is subject to multiple regulatory standards in the markets they serve, including safety, fuel economy, emissions control and chemicals use. In addition, the industry must comply with regulations related to government contracting and international trade. In the U.S., several agencies within the federal government have jurisdiction over various aspects of the Aerospace & Defense industry.

To comply, companies bear heavy costs. In addition, certain U.S. government contracts span one or more base years and multiple option years. The U.S. government generally has the right not to exercise option periods and may not exercise an option period for various reasons, which in turn might hamper revenue growth of defense corporations.

Further, companies in this industry must manage price and environmental expectations in order to meet government requests for proposals (RFPs), which seek to align contract work with broader government goals. In trying to meet such regulations, at times, companies are compelled to forgo a part of their profits; which in turn affects the growth of the entire sector.

Budget Loopholes : The recently proposed FY 2018 defense budget and the appropriations put forward by Trump's administration for FY 2017 are expected to bring in military stability. But one cannot overlook the risk of an economic downturn.

Indeed Trump's FY 2018 budget proposal itself seems to be a threat to the growth of the nation's economy. While the 'America First Budget' proposed a 10% hike in the defense spending, to avoid any further budget deficit, Trump's plan includes a simultaneous decline in spending in non-defense programs, particularly foreign aid, agriculture, commerce, education, energy, environment protection agency (EPA) and health.

Now it is true that increasing fiscal budget deficit put immense pressure on an economy under huge debt, slowing down its growth trajectory. But to ensure a balanced budget, it is not wise to sacrifice the other pillars of the economy. Stability in economy is not guaranteed only by the departments of justice, defense and homeland security. Neither does social security depend only on the strength of a defense system. Qualities of health, education as well as environmental services are also crucial to a nation's well-being. Many analysts fear that such deep cuts in these sectors that offer the basic amenities of life might shake the very foundation of the U.S. economy.

Among the sectors that will suffer the most, the EPA's operating budget would be cut by 25% eliminating approximately 3,000 jobs and reducing its total staff from 15,000 to 12,000. This would not only raise the unemployment rate but also hurt programs dealing with air and water pollution and climate change research.

Indeed, Trump's budget seems to have created an economic conflict in America, with concerns that reducing funds for these important industries might do more harm than good. Going forward, under Trump's planned budget cuts, federal spending is likely to see a $10.5 trillion reduction over 10 years. However, if the reduction is not even among all federal departments, everyone will suffer severe economic repercussions in times of recession.

Also, the 10% hike promised by Trump in FY 2018's defense budget might not be kept if the $30 billion appropriations that he proposed for FY 2017 are accepted.

Rate Hike & Strong U.S. Dollar : A gradually recovering economy, at least in the near term, with increased consumer spending and lower unemployment has set the stage for a series of rate hikes in the U.S. As a result, we witnessed a hike of a quarter-point in the lending rate last month, following last December's hike and projections of two more hikes this year. Although rate hike reflects stability in the economy, it pumps up the credit rate that banks extend to their customers. Aerospace defense being a highly capital intensive industry, such a rate hike is not good news for its expansion.

Also, a rate hike magnifies borrowing costs for the government, thereby raising national debt. Presently, the national debt is approximately $20 trillion, which itself raises questions as to whether adding more to this number will prove any wiser. Higher public debt might drag the economy to the path of decelerated growth and put pressure on U.S. taxpayers.

Moreover, positive economic data boost expectation of more rate hikes from the U.S. Federal Reserve which in turn leads to the U.S dollar appreciation. This affects U.S.-based companies as a strong dollar is not only proving to be a currency translation drag, but is also having a bearing on foreign military sales.

With the Fed set to hike rates twice this year, dollar should also be on an uptrend. As a result, U.S.-based defense companies earning from overseas operations will be deeply affected. A stronger dollar might also damage the nation's export competitiveness.

Intense Competition : Aerospace and defense companies vie among themselves for a finite number of small and large programs.

Moreover, China is developing space technologies aimed at blocking U.S. military communications, per a report commissioned by a panel formed by Congress. China's goal is to become a space power as forceful as the U.S. and to promote a space industry equal to those in the U.S. and Europe.

In the same line of action, as per a report by CNBC, Russian defense officials have acknowledged deploying radar-imagery jammers and developing laser weapons designed to blind U.S. intelligence and ballistic missile defense satellites. Russia and China continue to pursue weapon systems capable of destroying satellites on orbit, placing U.S. satellites at greater risk for the next few years.

North Korea has also been giving the U.S. a hard time lately on the defense frontier. Last month, the two countries got engaged in a hostile missile rift when North Korea fired four ballistic missiles into the waters off its east coast. In retaliation, the U.S. military deployed Lockheed Martin Corp.'s (LMT) THAAD anti-ballistic missile system in South Korea.

Given the looming headwinds, we advise investors against names that offer little growth/opportunity over the near term. These include companies for which estimate revision trends reflect a bearish sentiment.

We remain apprehensive of Zacks Rank #4 (Sell) stocks like General Dynamics, Inc. (GD), AAR Corp. (AIR) and Wesco Aircraft Holdings, Inc. (WAIR). You can see the complete list of today's Zacks #1 Rank (Strong Buy) stocks here .

Our Take

It is true that the aerospace & defense industry has remained mostly stable amid economic downturns, thanks to its non-cyclical nature. On top of that, the rise in global geopolitical uncertainty is expected to bring good fortunes for it.

Yet we cannot overlook issues like global competition, rapid changes in technology, national and worldwide economic conditions and global policies affecting defense stocks. Also, aerospace manufacturers now giving more emphasis on commercial aviation.

The fast-changing world with rising global uncertainty requires the aerospace and defense industry to act with speed and flexibility. We believe that careful management and prudent spending will help the industry to overcome its headwinds.

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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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