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Consolidations to Lift 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 defense players. A prominent stock in this industry is Transdigm Group Inc. (TDG).

Here are the three major industry themes:

  • While rising competition has frequently 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, aerospace parts makers and suppliers, Hexcel Corporation (HXL) and Woodward entered into an all-stock merger of equals agreement in January. The deal, worth $6.4 billion, will give birth to one of the top independent aerospace and defense suppliers globally. Such consolidations by leading industry players should improve economies of scale for the aerospace-defense equipment industry as a whole. 
     

  • Being the largest digitally advanced nation, the United States is rapidly enhancing its electronic warfare, C4ISR (Command, Control, Communication, Computers, Intelligence, Surveillance and Reconnaissance) and cyber security measures, following frequent cyber-attacks that affected a number of countries last year. According to Markets and Markets firm, the global C4ISR market is expected to witness CAGR of 3.6% from 2017 to 2022 to reach $119.4 billion, with North America dominating the market. This should further boost prospects of the stocks in this space, especially those providing defense electronics.
     

  • U.S. labor market statistics apparently 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. To this end, 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 growth of the 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 #186, which places it in the bottom 27% 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 bright 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 1.7% since Dec 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 Outperforms S&P 500 and Sector

The Aerospace-Defense Equipment industry has outperformed the Zacks S&P 500 composite as well as its own sector over the past year. The stocks in this industry have collectively gained 45.8%, while the Aerospace sector has gained 26.9%. However, the Zacks S&P 500 composite has rallied 27.6% 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 2.55X compared with the S&P 500’s 3.29X and the sector’s 1.75X.

Over the past five years, the industry has traded as high as 2.55X, as low as 1.91X, and at the median of 2.32X, as the charts show below.

EV-Sales Ratio (TTM)

Bottom Line

The fiscal 2020 budget indicates 5% growth from last fiscal’s approved budget spending. Such hawkish spending provisions for the U.S. Department of Defense (DoD), along with accelerating commercial aircraft production on account of rapidly rising global air traffic, should keep U.S. Aerospace-Defense Equipment stocks’ momentum alive.

Although the industry’s dismal rank and workforce related issue remain concerns, considering its price performance history and merger-oriented growth prospects, investors may bet on a few stocks from the space that exhibit a strong earnings outlook.

We are presenting three aerospace-defense equipment stocks with a Zacks Rank #1 (Strong Buy) or #2 (Buy) that investors may want to add to their portfolio. You can see the complete list of today’s Zacks #1 Rank stocks here.

Raytheon Company (RTN): The Zacks Consensus Estimate for this Waltham, MA-based company’s current-year earnings indicates year-over-year improvement of 8.4%. The company has a four-quarter positive earnings surprise of 8.6% on average. It holds a Zacks Rank #2.

Teledyne Technologies (TDY): For this Thousand Oaks, CA-based company, the Zacks Consensus Estimate for current-year EPS indicates year-over-year improvement of 9.2%. It has a four-quarter positive earnings surprise of 10.13% on average. It carries a Zacks Rank #2.

HEICO (HEI): For this Hollywood, FL-based company, the Zacks Consensus Estimate for fiscal 2020 EPS indicates year-over-year improvement of 5.4%. It came up with average four-quarter positive earninsg surprise of 112.27%. It sports a Zacks Rank #1.

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Teledyne Technologies Incorporated (TDY) : Free Stock Analysis Report
 
Transdigm Group Incorporated (TDG) : Free Stock Analysis Report
 
Raytheon Company (RTN) : Free Stock Analysis Report
 
Hexcel Corporation (HXL) : Free Stock Analysis Report
 
Heico Corporation (HEI) : Free Stock Analysis Report
 
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