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Aerospace and defense sector may keep flying high for years to come

There's no shortage of demand for weapons systems, fed by a larger defense budget.

  • By Philip Van Doorn,
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Stock prices tend to be driven by increases in earnings. The federal income tax cuts that went into effect this year will no doubt boost profits and potentially share prices. But that party will surely end, after which it is reasonable to expect the aerospace and defense subsector to continue to outperform the broader market.

Before getting to comments from three veteran money managers about aerospace and defense (A&D) stocks, here are two sets of data illustrating how much better large-cap A&D stocks have performed when compared with the benchmark S&P 500 Index (.SPX), and how much more their earnings are expected to grow after the tax-cut euphoria ends.

Here’s how the performance of the S&P 500 Aerospace and Defense subsector has compared to that of the S&P 500 Index over various periods through Sept. 14:

Here are earnings-per-share (EPS) numbers for 2016 and 2017, as well as EPS projections for the next two years, based on consensus estimates of analysts polled by FactSet:

Here are EPS growth numbers and projections based on the above:

The 2018 spike is obvious, but looking out to 2019 and 2020, the S&P 500 EPS increases are expected to be significant, and the aerospace and defense subsector is expected to show much more impressive increases.

Under the Budget and Control Act of 2011, U.S. military spending was capped at $550 billion a year, but spending during fiscal 2017 actually totaled $590 billion, according to the Congressional Budget Office. President Trump signed the National Defense Authorization Act for fiscal 2018 into law in December, which authorized a total of $692 billion in defense spending.

Examples of exchange traded funds (ETFs) that hold defense stocks include the SPDR S&P Aerospace & Defense ETF (XAR) and the iShares U.S. Aerospace & Defense ETF (ITA), which tracks the Dow Jones U.S. Select Aerospace & Defense Index.

Large-cap defense stocks

Gary Bradshaw, who co-manages four funds for Hodges Mutual Funds, and Randy Hare, director of equity research at Huntington Private Bank, discussed major U.S. defense contractors in recent interviews with MarketWatch.

Lockheed Martin

Here are projected sales and earnings increases (based on consensus estimates of analysts polled by FactSet) for Lockheed Martin (LMT), the manufacturer of the F-35 Lightning II, known as the Joint Strike Fighter:

Like many companies, Lockheed Martin took a large fourth-quarter accounting charge to write down deferred tax assets because of the massive federal tax cut. That and the lower tax rate in 2018 feed a distorted number for expected EPS growth in 2018. But as you can see, analysts expect double-digit increases in EPS in 2019 and 2020.

Bradshaw said F-35 deliveries were “ramping up,” as “they have gotten the bugs worked out of that plane,” now that most testing has been completed, and because many other countries have been involved in the fighter’s development. The F-35 was first used in combat by the Israeli Air Force in May.

Hare said Lockheed would be boosted by the lifting of restrictions on foreign sales of its Terminal High Altitude Area Defense Weapon System.

The stock trades for 19.6 times consensus 2018 EPS, which isn’t cheap when compared to a P/E ratio of 18 for the S&P 500, but the expected EPS growth supports the higher valuation. Bradshaw sees large defense stocks as solid plays even at current levels because of stable recurring revenue and dividend growth — Lockheed Martin increased its dividend by 10% in December. “We think [defense-stock] valuations will stay where they are and stocks will follow earnings growth,” Hare said.

Hare is a believer in Wall Street’s lofty projections for Lockheed’s earnings growth because the company is making unusually large contributions to its pension fund this year.

“I think Trump will continue boosting the military,” Bradshaw said. And even if the military budget does not increase again in fiscal 2019, Hare expects large contractors’ revenue to continue to increase because of spending on operations and maintenance.

Northrop Grumman

Here are projected sales and earnings increases for Northrop Grumman (NOC):

Hare expects “maybe a bit more earnings growth” over the long term for Northrop Grumman from its acquisition of Orbital ATK, which was completed in June.

It is not known if the U.S. Space Force that Trump has proposed will lead to an actual increase in spending (as the Air Force, Army and Navy all have space operations). However, Hare believes that a fifth armed-services branch “highlights the need” for more space spending.

In the meantime, the company is “the lead bidder for the next concept of the GPS3 system,” Hare said, referring to the satellite system. He also believes the B-21 Raider bomber program, which is under development, will “continue to provide upside” for Northrop Grumman.

Raytheon

Raytheon (RTN) makes weapons systems, including Patriot Air and Missile Defense and Tomahawk cruise missiles. Here’s how analysts expect the company’s sales and earnings to increase this year and the following two years:

Bradshaw said the periodic use of Tomahawk cruise missiles “keeps [Raython’s] backlog peaking out.” (Trump last ordered them used in April 2017, after the Syrian government was accused of killing civilians during a poison gas attack.)

Bradshaw also pointed to significant dividend increases by the company. Raytheon most recently increased the payout by 9% in March.

Boeing

Boeing’s (BA) aircraft backlog is still growing. Here are projected sales and earnings growth numbers:

“We were buying the stock back at $74 [the stock last closed below $75 in November 2012] when the Dreamliners were having fires with the batteries," Bradshaw said.

When you consider that batteries are simpler components than, say, the structure of an airplane’s body or wings, this might have been an excellent “buy” signal for contrarian investors. Bradshaw said that, at the time, he considered the battery problem a “glitch.”

While Boeing manufactures several aircraft models for military use, Bradshaw said he was still a long-term believer in the stock because of healthy demand for commercial airplanes.

He also was thrilled that Boeing raised its dividend by 20% in December.

Small-cap stocks

Bill Hench co-manages the small-cap Royce Opportunity Fund (RYPNX), which has $1.3 billion in assets.

“The nice thing about this industry is you do not have to guess what is going to happen,” Hench said in an interview when he discussed the moves by Congress and Trump to increase defense spending.

He pointed to significant barriers to entry for defense contractors of all sizes as being an important advantage for the subsector. And with “a lot of dollars” for the F-35, missile programs and new programs, “we are looking at names that fit into that: Components makers, parts markets and, to a lesser extent, the metals and mining category: titanium, aluminum, things that go into airplanes,” he said.

He named two companies that “do highly engineered work on stainless steel, titanium or alloys, for aviation, medical products and industrial uses.” Those are Carpenter Technology (CRS), and Haynes International (HAYN) — two companies that would not show up if you did a screen on small-cap aerospace and defense contractors, even though Hench called them “key suppliers” to defense contractors.

Here are projected sales and earnings growth figures for Carpenter Technology, based on analysts’ consensus estimates:

And for Haynes International:

Haynes International lost 83 cents a share in 2017 and is expected by analysts to post a loss of 6 cents a share for 2018. Earnings are expected to come in at a positive $2.11 a share in 2019 and to rise to $3.41 in 2020.

Wesco Aircraft Holdings

Hench likes Wesco Aircraft Holdings (WAIR) as “purer play” in aerospace. Here are sales and earnings growth projections:

The company supplies components and supply-management services to more than 7,000 customers around the world, mainly in the aviation sector.

Aerospace and defense as ... defensive investments

Hench pointed to barriers keeping competitors away: “You and I are not going to form a company that makes landing gear tomorrow, from scratch. It is highly specialized and tough to get new entrants.”

“You can also look at what’s happening in the satellite world. You have seen satellites for commercial and defense multiply. It is only going to grow” from here, he said.

“In a market where people are worried about trade and interest rates, this is a well-established channel with good funding,” Hench added.

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