Will Cuts in Major Weapons Programs Hurt Defense Stocks?

Granted that economic data has turned more positive lately and geopolitical uncertainty has improved the outlook for the broader defense space, but issues remain. A faster-than-expected rise in interest rates and "disproportionate" cuts to modernization and research and development funding could act as major impediments for a defense industry that is already facing major volatility lately.

Below we have discussed the headwinds that might spoil the prospects of the aerospace and defense sectors in the near term.

Strong U.S. Dollar: The major headwind for the defense players is the strong U.S. dollar, which is a reflection of the growth and monetary policy divergence between the U.S. and its trading partners. This has become a major headwind for U.S.-based companies as the strong dollar is not only showing up as a currency translation drag, but is also having a bearing on foreign military sales. We saw this in the results of all major industry players including United Technologies UTX.

Moreover, the strong labor market data in November raised expectations that the Federal Reserve will raise interest rates at its next meeting on Dec 15-16. It has kept its benchmark rate at a record low for seven years. The dollar is expected to gain further from the series of rate hikes that the Fed is planning. A stronger dollar would dent the Fed's efforts to boost domestic inflation and could damage U.S. export competitiveness.

Will Weapons Programs Be Hit in Fiscal 2017 Budget?: Earlier this month, Frank Kendall, undersecretary for acquisition, technology and logistics, said in a conference hosted by the Potomac Officers Club that the Pentagon expects to make "disproportionate" cuts to modernization and research and development funding in its fiscal 2017 budget request. This may imply a possible slowdown in production rates of Lockheed Martin Corp's LMT F-35 fighter jet – the single largest weapons program of the Pentagon.

While Kendall divulged no further details on the possibility of the expected cut in production of the F-35 fighter jet, he made it clear that it would not be feasible to defend the new jets entirely in the current budget environment. He expects that certain limitations on the budget related to training, personnel costs and force structure may implicate a major hit on weapons programs in the fiscal 2017 budget plan.

And nothing is a bigger target than the F-35 program. Hence, some defense suppliers may have to migrate their business models toward other channels to offset the secular decline in U.S. Department of Defense (DoD) weapons-related procurement.

Economic Picture: The U.S. has been the world's largest defense consumer since World War II. Iraq and Afghanistan wars in the past decade boosted spending, driving it to historic heights. However, the winding down of those wars and severe pressure to lower the national debt burden following the country's major financial distress since the Great Depression have cast a long shadow over the U.S defense budget. Although the defense market received the latest two-year budget deal with much enthusiasm as it brought military stability, one cannot overlook the risk of an economic downturn.

A country's ability to spend on defense is a function of its economic health. The same is true at the global level – the faster the global economy grows, the higher the defense spending. Following the global crisis in 2008, there was a marked shift in defense spending growth from the developed to the emerging countries.

Notably, the overall U.S. economy, as measured by the gross domestic product or GDP, increased at an annual rate of 2.1% in the July-September period, per the Commerce Department report. This was down from the second quarter's notable 3.9% growth rate. Government spending grew at a 1.7% rate as strength in state and local spending offset a big drop in defense spending.

Although GDP growth will likely accelerate slightly to around 2.5% for 2015, economists are anticipating that 2015 will be another year of only modest economic growth.

Intense Competition: The aerospace and defense companies compete among themselves for a number of small and large programs.

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

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 on the Zacks Rank #4 (Sell) stocks that include Aerojet Rocketdyne Holdings, Inc. (AJRD), Astronics Corporation ATRO, Hexcel Corp. HXL, Kratos Defense & Security Solutions, Inc. KTOS and FLIR Systems, Inc. FLIR.

In addition, we are skeptical of these Zacks Ranked #5 (Strong Sell) stocks: Ducommun Inc. DCO, KLX Inc. (KLXI) and LMI Aerospace Inc. LMIA.

Our Take

In "Is Defense Looking Good on ISIS Threats, Budget Stability?, we focused on the conditions which are expected to drive the industry forward.

The industry's position is now challenged by global competition, changes in technology, national and worldwide economic conditions and global policies affecting defense, civilian and commercial aviation.

The fast-changing world with rising global uncertainty demands the defense sector to act with speed and flexibility. With careful management and prudent spending the sector is expected to weather the headwinds effectively.

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