Factors That May Unsettle Stable Defense Stocks

Granted that geopolitical uncertainty has improved the outlook for the broader defense space, there are still certain issues holding the sector back. The global markets witnessed a Brexit-begotten June and the sell-off induced by that event. On top of it, weak second-quarter economic data has certainly put the brakes on the positive momentum.

Apart from tepid economic data, "disproportionate" cuts to modernization and research and development funding could act as major impediments for the defense industry.

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

Brexit Effect: The U.S. and the U.K. maintain a close tie when it comes to national security matters. Britain-based companies, such as, BAE Systems (LON:BAES), develop platforms for the U.S. military, and the British military buys goods from U.S. companies, such as the F-35.

Among the biggest purchases between the two countries, the U.K has plans to buy 138 F-35Bs from Lockheed Martin Corp (NYSE:LMT). (LMT). The decreasing value of the pound means the price tag on these joint-strike fighters will go up in the short term. Although this may not hold in the long term, Brexit could weaken the British pound and the euro in the near term, prompting countries to scale back purchases of American-made weapons, such as, the F-35 Joint Strike Fighter, which is being bought by Britain, the Netherlands, Denmark and Italy.

A Positive-But-Cautious Fed Meet: As expected, the Fed stayed put in its July policy meeting and kept the short-term interest rates steady in the 0.25–0.50% band. Although the Fed painted an encouraging picture and said other indicators were pointing to growth, it still believes the domestic economy is still too vulnerable to move rates beyond the 1/4 to 1/2% it established seven months ago.

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 had 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 will be 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, U.S. gross domestic product or GDP, the broadest measure of goods and services produced across the U.S., grew at a seasonally adjusted annual rate of 1.2% in the second quarter, well below market expectations. With this, the economy has grown at less than a 2% pace for three straight quarters.

The gain marks only a slight acceleration from the first quarter, when GDP advanced at a downwardly revised 0.8% pace. The first quarter was previously seen as increasing 1.1% from the prior period.

Moreover, the White House has released figures showing that the FY 2016 budget deficit will be $162 billion more than originally projected. That brings the deficit back up to $600 billion after a few years of declining deficits from a high of $1.4 trillion in 2010.

Strong U.S. Dollar: A gradually recovering U.S. economy, slower global growth and expectations of more rate hikes from the U.S. Federal Reserve had led to the U.S dollar appreciation. This has affected 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.

Although the Fed has held itself from raising interest rates again given market jitters and Brexit concern, it will ultimately resume rate hikes. It has kept its benchmark rate at a record low for seven years. The dollar is expected to gain further if the rates start to climb north. A stronger dollar could damage U.S. export competitiveness.

Will Weapons Programs Be Hit in Fiscal 2017 Budget?

The U.S. Department of Defense (DoD) announced this February that it plans to purchase fewer F-35 fighter jets from Lockheed Martin over the next five years than it had originally planned. The Pentagon’s next five-year plan, beginning fiscal 2017 through fiscal 2020, covers the purchase of 299 jets (down by 37 units from the previous expectation). Total funding – procurement, research, and development – drops from $11.602 billion in FY 2016 to $10.504 billion in the FY 2017 proposal.

Certain limitations on the budget related to training, personnel costs and force structure may have an implication on weapons programs in the fiscal 2017 budget plan.

Lockheed Martin's F-35 fighter jet is undoubtedly the single largest weapons program of the DoD. Apart from that, total funding proposal for the P-8A Poseidon program – procurement, research, and development – in FY 2017 dropped to $2.165 billion from $3.373 billion in FY 2016. Funding proposal for FY 2017 for Stryker, the Amphibious Combat Vehicle (ACV), DDG 51 Arleigh Burke destroyer along with Space Based Infrared System (SBIRS) and the DoD’s Global Positioning System (GPS) program has also witnessed a sharp decline.

Some defense suppliers may have to migrate their business models toward other channels to offset the secular decline in weapons-related procurement.

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

Moreover, China 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 as 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 of Zacks Rank #4 (Sell) stocks like BAE Systems plc (BAESY), CPI Aerostructures Inc. (CVU), Curtiss-Wright Corp. (CW), Esterline Technologies Corp. (ESL), LMI Aerospace Inc. (LMIA) and Moog Inc. (MOG.A).

In addition, we are skeptical of these Zacks Ranked #5 (Strong Sell) stocks: Embraer SA (ERJ), AAR Corp. (AIR) and Triumph Group, Inc. (TGI).

Our Take

In “Is “War On Terror” a Boon for the Defense Industry?” 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 requires the defense sector to act with speed and flexibility. With careful management and prudent spending the sector is expected to weather the headwinds effectively.