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Aerospace & Defense Stock Outlook – Dec. 2015

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The importance of the aerospace & defense industry stems from the strategic role it plays in the country’s security. As threats turn into ever new shapes involving asymmetric, air-sea power, cyber, urban, non-state organizations, and many more, the defense capabilities of a country need to morph accordingly to contain them.

A politically unstable planet has led to various nations stepping up their defense capabilities. The direct beneficiary of a volatile geo-economy is undoubtedly the aerospace and defense players. The U.S. defense firms have particularly tasted success 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 Islamic State of Iraq and Syria (ISIS), a situation that President Obama coined “the network of death.”

Moreover, the aerospace and defense industry has gained from fleet renewals at airlines worldwide. Demand for more fuel-efficient aircraft, a growing international market and increasing application of unmanned aircraft in warfare today have driven up sales in this sector.

On top of it, the recent budget agreement is a net positive for the defense players. Given the signs of an improving labor market, the U.S. economy is also on track to grow 2.3% in the final quarter of 2015, per the Atlanta Federal Reserve’s GDPNow forecast model.

Budget Updates

On Nov 25, 2015, President Obama signed a $607 billion annual defense policy bill. The bipartisan budget deal gives the U.S. Department of Defense (DoD) big-time relief, raising the 2016 spending cap by $33 billion and the 2017 cap by $23 billion. That allows the Pentagon to get a total of $607 billion in 2016 and $610 billion in 2017.

Though the budget agreement provides $5 billion less than what the President had requested for fiscal 2016, it increased the security spending limit by about $25 billion or about 5% to $548.1 billion for the fiscal over fiscal 2015. It also provided $58.8 billion in funding for the Pentagon’s separate war fund, the overseas contingency operations (“OCO”) fund.

Overall, the new budget deal provided the Pentagon with a two-year budget certainty. This is especially important as defense programs require long-term strategic planning and multi-year acquisition contracts. Again, the agreement gives the military a higher budget than it would have witnessed under the spending caps. This provides some respite following six consecutive years of budget austerities.

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 257+ 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.

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.

Aerospace/defense is positive with a Zacks Industry Rank #19. The Zacks Industry Rank for Electric-military is at #106 out of 257 industries, which puts it in a neutral zone. Aerospace/defense equipment with a Zacks Industry Rank #210 comes in the bottom one-third or in the negative zone of all Zacks industries.

Earnings Review and Outlook

Every fiscal year, no matter how constrained the funding picture, the Pentagon almost always gets its way. A classic example can be drawn from the recent third-quarter earnings session wherein the earnings beat ratio (percentage of companies coming out with positive surprises) of all aerospace and defense companies was an impressive 77.8%. They were not only up against the fiscal 2015 budget constraints but were also subject to tepid economic growth throughout the quarter.

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. In spite of the macro issues, the top contractors, such as Lockheed Martin Corp. (LMTAnalyst Report), The Boeing Co. (BAAnalyst Report), Northrop Grumman Corp. (NOCAnalyst Report), General Dynamics Corp. (GDAnalyst Report), Textron Inc. (TXTAnalyst Report), Raytheon Co. (RTNAnalyst Report) have held up well this past quarter given the elevated geopolitical risk and strong commercial sales.These companies have not only reported better-than-expected results but also lifted their views in most cases. A combination of cost cutting, stock buybacks and earnings gains from businesses outside the federal market helped to minimize the pain for investors.

The picture is still somewhat gloomy as the aerospace sector’s earnings are expected to decline 11% in the fourth quarter, as against the 2.4% earnings growth notched up in the third despite the challenges faced by the sector. Revenues too are expected to decline 2.9% overall (versus 4.1% growth in Q3) while margins are expected at 7% (versus 7.4% growth in Q3).

For the S&P 500, earnings are expected to decline at a rate of 6.5% and revenues will likely take a hit of 3.4% in the fourth quarter.

To Sum Up

While there are various other variants that affect the stock market, the terror spawned by ISIS sparked renewed anger around the world following the Paris attacks. This has drawn investors’ attention once again to defense stocks.

Amid the ups and downs of Federal budgets, we advise investors to consider this trouble-free and proven investment strategy of putting in money where the fundamentals are strong. Despite a multitude of challenges, the long-term outlook for the defense industry has held up pretty well.

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