Rising geopolitical tensions along with rapid economic growth in emerging markets have pushed up demand for U.S. weapons exports to an all-time high, eventually benefiting the U.S. defense manufacturers.
Given the budget challenges, the defense primes are working on (i) how to grow profitably from diminishing budgets and (ii) slash costs for maintaining a satisfactory financial condition.
Next-generation technology: At the macro level, there has been a gradual shift in defense spending patterns. In response to asymmetric terrorist threats, the emphasis appears to have shifted to high-tech intelligence equipment, replacing demand for conventional big guns and heavy armor.
The major industry players have, in response, resorted to bolt-on acquisitions to plug gaps in their product offerings. A focus on R&D is also helping these companies to develop next generation technologies essential in a climate of fewer programs and reduced budgets.
Defense companies will increasingly be required to come up with next generation intelligence, surveillance and reconnaissance (ISR) technologies. The contractors specializing in space systems will continue to gain from the Pentagon's increasing focus on its space division to counter emerging security threats.
Given the vital role played by satellites in the military space, Pentagon's prime contractor and the world's largest defense company Lockheed Martin Corp. (LMT) is looking to bolster its satellite product coverage by increasingly investing in R&D and acquisitions. Although Lockheed ran up against F-35 glitches earlier this year, this program will definitely trigger significant top-line generation for the company. The recent defense spending bill for fiscal 2015 (beginning Oct. 1) includes 38 new F-35 fighters.
Foreign Military Sales (FMS): The big defense operators are also expanding their operations through acquisitions and foreign orders. FMS remains the key tool for boosting their top line. The ongoing Iraqi civil war, escalating tensions in Eastern Europe and demand for defense products in the Middle East and other Asian nations keep alive the hopes for this sector. A number of emerging markets as well as nations such as India, Japan, the United Arab Emirates, Saudi Arabia and Brazil are increasing defense spending and generating business for the U.S. aerospace and defense companies.
In fiscal 2014, U.S. military sales to its allies stood at $34.2 billion, according to the Defense Security Cooperation Agency. This marked a slight uptick from approximately $30 billion in sales in fiscal 2013.
Foreign military contracts also continue to be the vital growth driver at Raytheon Co. (RTN). The company's international sales are expected to rise in the mid-single digits, contributing 30% of projected 2014 sales.
The Boeing Co. (BA) is on the lookout for more international contracts to keep its top line rolling. Boeing is expanding its presence in cyber security, intelligence and surveillance and unmanned systems, where growth rates are higher than the overall defense budget.
Restructuring/Diversification/Acquisition: To maintain margins in a declining revenue environment, costs need to shrink. The operators are busy restructuring their businesses and engaging in prudent acquisitions. Another ploy utilized by these companies to avert budget austerities is to steadily diversify into the commercial aviation market. Commercial aviation is a comparatively newer industry, when compared to defense, with the sky as its literal limit. Increasing mobility in the emerging markets continue to drive this space.
Since the start of 2014, there have been a number of share price gainers with General Dynamics Corp. (GD) witnessing the highest increase of around 43.8%. It is buoyed by consistent contract wins and cost-cutting initiatives that spurred profitability even as defense spending by the U.S. government remained low.
At the end of the third quarter 2014, General Dynamics' total backlog grew 55.7% year over year. The maker of Gulfstream jets, tanks as well as U.S. Navy ships is one of the two contractors equipped to build nuclear-powered submarines in the U.S. with the other being Huntington Ingalls Industries Inc. (HII).
In fact, Huntington Ingalls Industries seems to be more protected than other defense contractors from budget cuts as the U.S. defense department is expanding its fleet of submarines and destroyers and introducing a new version of aircraft carriers, particularly focused on the Asian-Pacific region.
HII also expanded its business with the UniversalPegasus International Holdings acquisition. The latter is a provider of engineering and project management services to the domestic and international energy markets. The deal marks Huntington Ingalls' entry into the oil and gas market.
Another defense contractor, Textron Inc. (TXT), is known to acquire assets having the same line of business, thus helping it to expand its core offerings. In fact, Textron has completed quite a few acquisitions, including TUG Technologies Corp. and Beech Holdings, LLC.
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In Jul 2014, the company's business arm TRU Simulation + Training Inc. acquired ProFlight, LLC, a leading innovative and advanced pilot training service provider. Its third-quarter performance benefited largely from the Beechcraft acquisition.
Beech Holdings has expertise in designing and manufacturing various types of aircraft, including the King Air turboprops, piston-engine Baron and Bonanza, and the T-6 trainer and AT-6 light attack military aircraft. Textron is already experiencing synergies from the deal having delivered 30 King Air during the third quarter.
Although sequestration casts a shadow of uncertainty on long-term funding for periods beyond fiscal 2015, if we are to pick the top defense stocks from the aerospace/defense sector for the near term, it would be Boeing, Engility Holdings, Inc. (EGL) and General Dynamics. These three stocks carry a Zacks Rank #2 (Buy).
In the aerospace/defense equipment industry, we are positive on Teledyne Technologies Inc. (TDY), Hexcel Corp. (HXL) and Spirit AeroSystems Holdings, Inc. (SPR). While Teledyne Technologies and Spirit AeroSystems sport a Zacks Rank #1 (Strong Buy), Hexcel carries a Zacks Rank #2.
Bottom Line
It is evident that the defense sector is playing well combating the budget austerity through various avenues. In the end they're growing profitably and lifting their outlook. But what about investing in the space right now – will the opportunities outweigh the risks to lure in short-term investors?
Check out our latest “Will a Rebounding US Economy Breathe New Life into Defense?” for more on the current state of affairs in this market from an earnings perspective, and how the trend is looking for this important sector of the economy now.
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