How Long Can Defense Stocks Soar?

Includes: BA, GD, LMT, NOC, OA, PPA, RTN, UTX
by: Scott Sacknoff

Aerospace and defense stocks have been on a significant run over the past year, reaching historic highs, with the SPADE Defense Index (ticker: DXS) up more than 40%, nearly double the return of the S&P500. Year-to-date, the sector has also outperformed the broader markets and is up nearly 28%, outperforming the broader markets by more than 700 basis points. And from the chart, the gap has accelerated over the past quarter.

Powershares Aerospace & Defense ETF (in blue) vs. the S&P500 in red

Chart: The one-year performance of the Powershares Aerospace & Defense ETF [PPA] (in blue) vs. the S&P500 (in red)

Investors have two questions….

  • Where does the sector go from here?; and
  • How long will it last?

To answer these, we turn to our analyst perspective and what the companies stated in their recent 2Q13 earnings reports:

Our Analysis

During the summer of 2011 investor's feared that spending on defense was past its peak as the wars in Iraq and Afghanistan wound down. Congressional "inaction" would lead to additional cuts via sequestration, and general budget pressures brought on by the declining economy only added to those fears.

Instead, what emerged was a more manageable budget restructuring (so far), a substantial increase in international defense sales, and the long-awaited boom in commercial aerospace. Combined, they have led the sector to rebounded to these new (and unexpected by many) highs. In retrospect, the budget decline came at the perfect time as upcycles and growth opportunities offset the worst-case scenario, gave firms time to solidify their balance sheets, and prepare to state their case for being a good investment until the next upcycle in defense spending.

But investors look forward not back. So from an analyst perspective, some key events can be seen as positives for the next six to 12 months:

1) The House recently passed a defense spending bill in the amount of $595 billion and the Senate Appropriations subcommittee on defense passed one as well. Although to be finalized, this will provide some stability and a top-line figure from which DoD can better plan spending through FY-2014. Still, with Congress there is always a risk, however considering its difficulty in passing "anything" the budget approval is a major step toward near-term stability.

2) The House included amendments that would shrink the funds used to help build Afghanistan's security forces by $553.8 million and another to prohibit "funds in the Afghanistan Infrastructure Fund from being used to commence new projects." The latter passed by a 332-94 bipartisan vote. These savings will go back into the Pentagon's budget and can offset some of sequestration's cuts. Additionally, the nation of Israel volunteered to have funding the U.S. provides to it for security in the region reduced by the same percentage that sequestration cuts are made stating that it wants to contribute "its share."

3) Although the Boeing (NYSE:BA) 787 Dreamliner has had a few problems, as most newly developed aircraft do, production instead of R&D spending should increase the sector's cash flow through the end of the decade and lastly;

4) Global spending on the acquisition of existing defense systems vs. a preference to invest to create in-country capabilities is on the rise. With a willingness by the U.S. Department of Defense and Congress to authorize sales to allied nations, global defense sales by U.S. firms have more than doubled in recent years with firms such as Lockheed Martin (NYSE:LMT) and Raytheon (NYSE:RTN) among those that have benefited.

Guidance from the 2Q13 Earnings Reports

Now let's take a look at what the companies are saying themselves about the prospects for the next six months.

  • United Technologies (NYSE:UTX): Beat profit estimates and lifted lower end of its yearly forecast. Said it is well-positioned for a return to organic growth in the second half of the year.
  • Lockheed Martin (LMT): Increased 2013 outlook for operating profit, earnings per share, and cash from operations. Raised earnings per share estimates to $9.20--$9.50. Repurchased 4.5 million shares for $465M. Cited workforce has declined from 146,000 in 2008 to 116,000 today. Backlog stands at $75.1 billion.
  • Alliant Techsystems (ATK): Increased its fiscal 2014 sales forecast to the range of $4.3-$4.38 billion from the prior outlook of $4.05-$4.15 billion. Increased fiscal 2014 earnings guidance to $8.60-$9.00 per share from $7.50-$7.90. Increased free cash flow to $200-$225 million from $150--$175 million.
  • Raytheon : New booking in the 2nd quarter were $5.3 billion and total backlog is at $32.4 billion. The firm also repurchased 7.6 million shares YTD at an average price of $59.20. Raised the low end of its guidance by $300 million to $23.5 billion and increased earnings from $6.00-$6.10 from $5.75-$5.90.
  • Expects several large orders for its Patriot missile defense systems in the second half of the year, including a deal for 11 units from Qatar ($2 billion), Kuwait ($500 million but could expand further in coming years through related contracts for modernization, spares and services); and Turkey (weighing a large order of around $500 million initially). The Patriot system is already used by 12 countries - United States, Netherlands, Germany, Japan, Israel, Saudi Arabia, Kuwait, Taiwan, Greece, Spain, South Korea and UAE.
  • General Dynamics (NYSE:GD): Total backlog stands at $49.4 billion. The firm repurchased 6.6 million shares during the quarter. Its Aerospace segment saw revenues of $2.05 billion up 29% YoY and operating income of $389M up 51.4% from a year ago.
  • Northrop Grumman (NYSE:NOC): Total order backlog of $37.7 billion. Increased guidance by $300 million (now $24.3B) and raised earnings to $7.60-$7.80 from $6.85-$7.15. Received new contracts worth $5.5 billion. Repurchased 6.1M shares of common during the 2nd quarter, for a 12.6 million total repurchase in the first half of 2013. The goal is to acquire 60 million shares by the end of 2015.
  • Boeing : Raised adjusted earnings to $6.20--$6.40 per share up from $61.20--$6.30 and increased revenue estimates for the year by $1 billion on higher orders. Backlog stands at $390 billion including $114 billion in orders this year

The take-away is that the companies operating in the sector see continued strength in their performance through the end of the year.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: The author manages the SPADE Defense Index (NYSE: DXS) which has been licensed and serves as the underlying index for the Powershares Aerospace & Defense ETF (NYSEARCA:PPA)