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Sept. 19, 2018, 7:03 a.m. EDT

Aerospace and defense sector may keep flying high for years to come

There’s no shortage of demand for weapons systems, fed by a larger defense budget

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By Philip van Doorn, MarketWatch


Bloomberg
Lockheed Martin’s F-35

Stock prices tend to be driven by increases in earnings. The federal income tax cuts that went into effect this year will no doubt boost profits and potentially share prices. But that party will surely end, after which it is reasonable to expect the aerospace and defense subsector to continue to outperform the broader market.

Before getting to comments from three veteran money managers about aerospace and defense (A&D) stocks, here are two sets of data illustrating how much better large-cap A&D stocks have performed when compared with the benchmark S&P 500 Index /zigman2/quotes/210599714/realtime SPX +0.10% , and how much more their earnings are expected to grow after the tax-cut euphoria ends.

Here’s how the performance of the S&P 500 Aerospace and Defense subsector has compared to that of the S&P 500 Index over various periods through Sept. 14:

Total returns with dividends reinvested
2018 3 years 5 years 10 years 15 years 20 years
S&P 500 Aerospace and Defense subsector 12% 101% 152% 333% 749% 924%
S&P 500 Index 10% 58% 91% 188% 288% 312%
Source: FactSet

Here are earnings-per-share (EPS) numbers for 2016 and 2017, as well as EPS projections for the next two years, based on consensus estimates of analysts polled by FactSet:

2016 EPS 2017 EPS Estimated 2018 EPS Estimated 2019 EPS Estimated 2020 EPS
S&P 500 Aerospace and Defense subsector $44.69 $49.81 $63.11 $71.56 $82.20
S&P 500 Index $118.55 $130.83 $161.11 $177.42 $193.80
Source: FactSet

Here are EPS growth numbers and projections based on the above:

2017 EPS increase Projected 2018 EPS increase Projected 2019 EPS increase Projected 2020 EPS increase
S&P 500 Aerospace and Defense subsector 11.5% 26.7% 13.4% 14.9%
S&P 500 Index 10.4% 23.1% 10.1% 9.2%
Source: FactSet

The 2018 spike is obvious, but looking out to 2019 and 2020, the S&P 500 EPS increases are expected to be significant, and the aerospace and defense subsector is expected to show much more impressive increases.

Under the Budget and Control Act of 2011, U.S. military spending was capped at $550 billion a year, but spending during fiscal 2017 actually totaled $590 billion, according to the Congressional Budget Office. President Trump signed the National Defense Authorization Act for fiscal 2018 into law in December, which authorized a total of $692 billion in defense spending.

Examples of exchange traded funds (ETFs) that hold defense stocks include the SPDR S&P Aerospace & Defense ETF /zigman2/quotes/203252291/composite XAR -0.33%  and the iShares U.S. Aerospace & Defense ETF /zigman2/quotes/207320401/composite ITA -0.24% , which tracks the Dow Jones U.S. Select Aerospace & Defense Index.

Large-cap defense stocks

Gary Bradshaw, who co-manages four funds for Hodges Mutual Funds, and Randy Hare, director of equity research at Huntington Private Bank, discussed major U.S. defense contractors in recent interviews with MarketWatch.

Lockheed Martin

Here are projected sales and earnings increases (based on consensus estimates of analysts polled by FactSet) for Lockheed Martin /zigman2/quotes/200691238/composite LMT -0.32% , the manufacturer of the F-35 Lightning II, known as the Joint Strike Fighter:

2018 sales 2018 EPS 2019 sales 2019 EPS 2020 Sales 2020 EPS
3% 148% 5% 13% 5% 24%
Source: FactSet

Like many companies, Lockheed Martin took a large fourth-quarter accounting charge to write down deferred tax assets because of the massive federal tax cut. That and the lower tax rate in 2018 feed a distorted number for expected EPS growth in 2018. But as you can see, analysts expect double-digit increases in EPS in 2019 and 2020.

Bradshaw said F-35 deliveries were “ramping up,” as “they have gotten the bugs worked out of that plane,” now that most testing has been completed, and because many other countries have been involved in the fighter’s development. The F-35 was first used in combat by the Israeli Air Force in May.

Hare said Lockheed would be boosted by the lifting of restrictions on foreign sales of its Terminal High Altitude Area Defense (THAAD) Weapon System.

The stock trades for 19.6 times consensus 2018 EPS, which isn’t cheap when compared to a P/E ratio of 18 for the S&P 500, but the expected EPS growth supports the higher valuation. Bradshaw sees large defense stocks as solid plays even at current levels because of stable recurring revenue and dividend growth — Lockheed Martin increased its dividend by 10% in December. “We think [defense-stock] valuations will stay where they are and stocks will follow earnings growth,” Hare said.

Hare is a believer in Wall Street’s lofty projections for Lockheed’s earnings growth because the company is making unusually large contributions to its pension fund this year.

 “I think Trump will continue boosting the military,” Bradshaw said. And even if the military budget does not increase again in fiscal 2019, Hare expects large contractors’ revenue to continue to increase because of spending on operations and maintenance.

Northrop Grumman

Here are projected sales and earnings increases for Northrop Grumman /zigman2/quotes/205518355/composite NOC -0.12% :

2018 sales 2018 EPS 2019 sales 2019 EPS 2020 Sales 2020 EPS
16% 47% 14% 13% 6% 10%
Source: FactSet

Hare expects “maybe a bit more earnings growth” over the long term for Northrop Grumman from its acquisition of Orbital ATK, which was completed in June.

It is not known if the U.S. Space Force that Trump has proposed will lead to an actual increase in spending (as the Air Force, Army and Navy all have space operations). However, Hare believes that a fifth armed-services branch “highlights the need” for more space spending.

/zigman2/quotes/210599714/realtime
US : S&P US
3,123.50
+3.04 +0.10%
Volume: 1.03B
Nov. 18, 2019 2:34p
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/zigman2/quotes/203252291/composite
US : U.S.: NYSE Arca
$ 112.24
-0.37 -0.33%
Volume: 69,300
Nov. 18, 2019 2:34p
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/zigman2/quotes/207320401/composite
US : U.S.: Cboe BZX
$ 233.12
-0.57 -0.24%
Volume: 89,578
Nov. 18, 2019 2:30p
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/zigman2/quotes/200691238/composite
US : U.S.: NYSE
$ 392.31
-1.25 -0.32%
Volume: 425,827
Nov. 18, 2019 2:34p
P/E Ratio
18.64
Dividend Yield
2.45%
Market Cap
$111.01 billion
Rev. per Employee
$512,019
loading...
/zigman2/quotes/205518355/composite
US : U.S.: NYSE
$ 356.25
-0.41 -0.12%
Volume: 307,436
Nov. 18, 2019 2:34p
P/E Ratio
18.35
Dividend Yield
1.48%
Market Cap
$60.11 billion
Rev. per Employee
$354,059
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