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Near-Term Outlook Dim for Aerospace-Defense Equipment Stocks

Aparajita Dutta

The Zacks Aerospace-Defense Equipment industry comprises firms that manufacture a wide variety of vital components for the aerospace-defense space, ranging from aerostructures, space shuttles, propulsion systems, aircraft engines, defense electronics, missile and radar systems to flight test equipment, structural adhesives, instrumentation and control systems, communication products and many more. A few of these companies also offer integrated simulation and training services to the U.S. defense force.

While the majority of revenues is generated from production of the aforementioned accompaniments, the industry players also generate revenues by providing notable aftermarket support and services like maintenance, repair and overhaul activities to aerospace and defense players. A prominent stock in this industry is Transdigm Group Inc. (TDG).

Here are the three major industry themes:

  • While rising competition has prompted industry majors to expand their product lines through small and medium-sized acquisitions, lately, there have been some big mergers in the industry. These can be attributed to the growing importance of cost reduction initiatives and increased control over production procedures. Speaking of such mergers, missile maker Raytheon Company completed its merger with aerospace electronics and communications provider, United Technologies in April 2020. The merger has created a premier conglomerate worth $121 billion, which is trading on the U.S. stock exchange with the name of Raytheon Technologies (RTX). Such consolidations by leading industry players should improve economies of scale for the aerospace-defense equipment industry as a whole.
     
  • The global airline industry plunged into an unprecedented crisis this March, as bookings plummeted drastically in response to increasing travel restrictions in the wake of the novel coronavirus outbreak. This in turn hit the entire aircraft production ecosystem, as evident from a notable reduction in and cancellation of commercial aircraft order as well as delayed deliveries of the same. Consequently, original equipment manufacturers (OEMs) and their suppliers witnessed a decline in revenues and cash flow. The pandemic also hit the commercial aftermarket industry. Since it is still uncertain as to when this pandemic and its resultant effects will ease, a prolonged demand crunch in commercial aerospace is expected, which makes us skeptical about the growth prospects of the U.S. Aerospace Defense equipment industry.
     
  • U.S. labor market statistics reflect strong growth trends with the nation’s unemployment rate reaching a 50-year low of 3.5% in September 2019. However, a deeper analysis shows that all is not well. The major issue is low labor force participation rate, which means fewer people are finding a place in the labor force — either because they lack the skills to enter it or are falling out of it. Now, the U.S aerospace-defense equipment industry, which employed more than 2.5 million workers as of the end of 2018, needs highly skilled labor. Unfortunately, U.S. population growth rate has been decelerating since 1992. So, the working-age population is not growing fast enough to meet the demand. A skills gap study from Deloitte and National Association of Manufacturers projected in 2018 that more than half of the 4.6 million manufacturing jobs created throughout the next decade will go unfilled. This remains a concern for aerospace-defense equipment industry.

Zacks Industry Rank Reflects Gloomy Outlook

The Zacks Aerospace-Defense Equipment industry is housed within the broader Zacks Aerospace sector. It currently carries a Zacks Industry Rank #217, which places it in the bottom 15% of more than 250 Zacks industries.

The group’s Zacks Industry Rank, which is basically the average of the Zacks Rank of all the member stocks, indicates weak near-term prospects. 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.

The industry’s position in the bottom 50% of the Zacks-ranked industries is due to a negative earnings outlook for the constituent companies in aggregate. Looking at the aggregate earnings estimate revisions, it appears that analysts have lost confidence in this group’s earnings growth potential in recent times. Evidently, the industry’s earnings estimates for the current fiscal year have gone down by 46.4% since Mar 31.

Before we present a few aerospace-defense equipment stocks that you may want to add to your portfolio, let’s take a look at the industry’s recent stock market performance and valuation picture.

Industry Lags S&P 500 and Sector

The Aerospace-Defense Equipment industry has underperformed the Zacks S&P 500 composite as well as its own sector over the past year. The stocks in this industry have collectively plunged 39.2% compared with the Aerospace sector’s decline of 31.1%. However, the Zacks S&P 500 composite has moved up 5% in the same timeframe.

One-Year Price Performance

Industry’s Current Valuation

On the basis of trailing 12-month EV/Sales, which is used for valuing capital intensive stocks like aerospace-defense equipment, the industry is currently trading at 1.3X compared with the S&P 500’s 2.88X and the sector’s 1.42X.
Over the past five years, the industry has traded as high as 2.05X, as low as 1.12X, and at the median of 1.50X, as the charts show below.

EV-Sales Ratio (TTM)

Bottom Line

The U.S. Aerospace-Defense Equipment industry’s dismal rank, workforce related issues as well as the impacts of the COVID-19 pandemic remain concerns, considering its price performance history.

Nevertheless, on the defense side of the industry, the situation appears less grim, with demand protected by budgeted government spending. It is imperative to mention in this context that fiscal 2020 budget indicates 5% growth from last fiscal’s approved budget spending. Considering such hawkish spending provisions and the inherent strength of the industry players, let us keeps our hopes alive for U.S. Aerospace-Defense Equipment stocks.

We are presenting three aerospace-defense equipment stocks, with Zacks Rank #3 (Hold), that investors may want to retain. You can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.

Kratos Defense & Security Solutions (KTOS): The Zacks Consensus Estimate for this San Diego, CA-based company’s current-year earnings indicates year-over-year improvement of 20.6%. The company has a four-quarter positive earnings surprise of 18.67% on average.

Ducommon Inc. (DCO): For this Santa Ana, CA-based company, the Zacks Consensus Estimate for current-year EPS has moved up 13.6% over the past 30 days. It has a four-quarter positive earnings surprise of 45.77% on average.

Astronics Corporation (ATRO): This East Aurora, NY-based company boasts a solid long-term earnings growth rate of 10%. It came up with average four-quarter positive earnings surprise of 13.33%.

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Transdigm Group Incorporated (TDG) : Free Stock Analysis Report
 
Kratos Defense Security Solutions, Inc. (KTOS) : Free Stock Analysis Report
 
Ducommun Incorporated (DCO) : Free Stock Analysis Report
 
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