The defense sector is up against an apathetic market as military budgets remain under pressure in the U.S. thanks to that dreaded word sequestration. The situation in Europe is even worse with defense budgets under pressure due to a slowing economy. This is bound to affect the sector’s 2014 top and bottom line.
Given the challenges, the defense primes are working on (i) how to grow profitably in a diminishing budget and (ii) slash costs for maintaining a satisfactory financial condition.
In retrospect, with more than six months of the year behind us, we can in all confidence say that these defense companies have carefully tended their revenue stream, picking up steady contracts, though small in value, from Pentagon’s funding list. Some big moves were also made keeping investors in good humor and ensuring gains for the overall sector.
Foreign Military Sales (FMS) has remained the key tool. 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.
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 Pentagon’s increasing focus on its space division to counter emerging security threats (Read: Lockheed Martin Clinches $1.9B GEO-5 and GEO-6 Satellite Contract) (Lockheed Wins Space Radar Contract)
Now to maintain margins in a declining revenue milieu, costs need to shrink. The operators are busy with acquisitions as well as business restructuring efforts. Recently, the Pentagon’s leading contractor Lockheed Martin Corp. (LMT) announced that it will freeze its defined benefit pension plan and move active salaried workers to an enhanced defined-contribution program in order to manage rising costs and reduce long-term liabilities.
Another ploy employed 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, driven by increasing mobility in the emerging markets.
Hence, the prospects for defense companies are still very much in place. With the second quarter earnings season in mind, it might be a good idea to bet on a handful of aerospace and defense stocks that are poised to beat earnings estimates.
Picking the Right Stocks?
Picking the right stock for your portfolio could appear to be a daunting task given the wide range of companies in the aerospace and defense space. One way to confine the list of choices during this earnings season is by looking at stocks that have a solid Zacks Rank accompanied by a favorable Earnings ESP.
Earnings ESP is our proprietary methodology for determining which stocks have the best chance to surprise with their next earnings announcement. It shows the percentage difference between the Most Accurate Estimate and the Zacks Consensus Estimate.
The combination of a favorable Zacks Rank – Zacks Rank #1 (Strong Buy), #2 (Buy) or #3 (Hold) – and a positive Earnings ESP is usually an indication of an earnings beat. Our research shows that for stocks with this combination, the chance of a positive earnings surprise is as high as 70%.
For investors seeking to apply this strategy to their portfolio, we have highlighted four defense stocks that may stand out this earnings season.
Huntington Ingalls Industries, Inc. (HII)
The largest military shipbuilder in the U.S., Huntington Ingalls is the prime industrial employer in Virginia. Huntington Ingalls, originally an affiliate of Northrop Grumman, was spun off in Mar 2011. It operates major shipyards in Louisiana, Mississippi and Virginia. Despite the budget austerity, we believe Huntington Ingalls will remain well-positioned backed by its effective execution skills and diverse product offerings.
The company currently has a Zacks Rank #2 along with an Earning ESP of +2.20%. Huntington Ingalls posted an earnings beat of 28.61% on an average in the last 4 quarters. The company is expected to report second quarter 2014 results on Aug 7.
B/E Aerospace Inc. (BEAV)
B/E Aerospace is the manufacturer of products for aircraft interiors. The company’s second quarter prospects look bright as it has an earnings ESP of +1.85% and a Zacks Rank #3.
In June, the company signed definitive agreements to acquire two manufacturing aerospace businesses – EMTEQ, Inc. and F+E Fischer + Entwicklungen GmbH & Co. KG (Fischer) – for about $470 million. Again, the company announced that it will split its business to form two independent public traded companies.
B/E Aerospace will break up the business into logistics, distribution and technical operation and aircraft seating and other cabin manufacturing operation. The spin-off would lead to cost synergies and increased operational flexibility for both the business arms.
The company is set to report second quarter results on Jul 23.
Raytheon Co. (RTN)
Raytheon is one of the largest aerospace and defense companies in the U.S. with a diversified line of military products, including missiles, radars, sensors, surveillance and reconnaissance equipment, communication and information systems, naval systems, air traffic control systems, and technical services.
FMS continues to be the vital growth driver for Raytheon. International sales are expected to contribute 30% of projected 2014 sales rising in the mid single digits. Despite a weak defense budget and the uncertainties surrounding the Tomahawk missile, international bookings made up 39% of total bookings in the first quarter.
For the last four quarters the company posted higher-than-expected earnings with an average surprise of approximately 15.74%. For the upcoming release, Raytheon has an earnings ESP of +3.77% and a Zacks Rank #3.
Raytheon will release second quarter results on Jul 24, prior to the opening bell.
The Boeing Co. (BA)
Boeing, carrying a Zacks Rank #3 (Hold), delivered a 13.78% positive surprise over the last four quarters on an average driven by solid operating performance and fueled by higher aircraft deliveries.
The company is also 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.
The Chicago-based premier jet aircraft manufacturer recently reported strong delivery numbers for the second quarter as well as the first half of 2014.
Boeing has an Earnings ESP +1.85%. The company is expected to report its second quarter 2014 results on Jul 23.
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