Could Aerospace & Defense Stocks Be Undervalued?

Surprised by title of this month’s SPADE Investor commentary? Well you are not alone.

Typically, I’ve tended to take a broader, longer-term view of the trends driving the aerospace and defense sector, but today I’m going to primarily focus on the short-term and statistics that many investors and financial analysts track.

For those with a longer investment horizon, past newsletters have mentioned a number of trends that should be a positive for the sector the next several years--a flattening defense budget that is projected to still see $33 billion of growth over the next five years; a commercial aerospace market operating at full manufacturing capacity that will soon reduce its R&D expenditures [and hence improve profits] as it enters a product delivery phase; a continued, growing market for homeland security products; reinvestment of defense hardware and systems used in Iraq; new and continued Defense department investments into next generation hardware and network centric products [which will position defense companies at the forefront of an eventual commercial market]; and expanding international opportunities.

But since I’ve said that, our focus today will be on what the short-term investor looks at:

1. For the first time since the SPADE Defense Index began a 20%+ decline in mid-November, the 10-day moving average has corrected to pass the 40-day and 200-day moving average. Starting the month at $20.92, the next level of resistance is at $22.50.
2. In April, the SPADE Defense Index outperformed the S&P500 by 209 basis points (2.09%) and is now trails the broader market by only 2% in 2008. After 8 consecutive years outperforming the broader market, a 9th is quite possible.
3. Delays in delivering the Boeing (BA) 787 have been priced into commercial aerospace stocks making it likely that the only news in the near future to move prices over the coming months will be to the upside.
4. The SPADE Defense Index declined over the previous three quarters for the first time in more than 10 years. More than half the time the index dropped more than 5%, the sector rebounded with better than 12% gains.
5. Nearly 30% of the Index has a PEG (price to earnings growth) of less than 1.00. More than half the constituents are below 1.25 and 83% are less than 1.50.
6. The forward P/E has declined from more than 17 to 14.12 and the forward P/S is 0.99, with earnings growth forecasted at 13.48%.
7. Companies continue to report significant growth in revenues and earnings, with several confirming or raising 2008 guidance in the recent quarterly earnings cycle.
8. Much of the sector’s decline since its all-time-highs in November 2007 can be attributed to “outside factors” and non-industry related events. As investors sought safety, they cashed out their best performers. And with the defense sector outperforming the S&P500 for eight consecutive years, the selloff in defense was noticeable. But with the market returning to more “normal” conditions, a return to defense and aerospace companies is becoming more attractive once again.

Lastly, offsetting all the positives in the short and the long-term are two key unknowns which are producing a drag on the sector, namely, the forthcoming election and the slowdown in growth of the defense budget.

Time will answer these two issue, but there is a growing understanding that their impact might not be as severe as some may believe.