With the Q1 earnings season off to a good start this year, the overall outlook for this reporting cycle has definitely improved buoyed by expectations of higher earnings as well as revenue growth compared to the prior quarter. As far as the defense sector is concerned, stocks in this space have been rallying over the past few months, courtesy of the ’big’ spending promises made by President Trump.
Evidently, major indices like the S&P 500 Aerospace & Defense Index (INDEX:SPSIAD) as well as the Dow Jones U.S. Aerospace & Defense Index rallied around 7% in the first quarter. Rising geopolitical uncertainties throughout the globe is expected to help defense companies maintain their outperformance in Q1.
Budget Proposals & Other Developments
On Mar 16, Trump unveiled the Pentagon’s fiscal 2018 (FY 2018) defense budget proposal of $639 billion. This reflects a $52 billion increase over the fiscal 2017 current budget level of $587 billion. Moreover, the base budget of FY 2018 reflects a 10% increase from the current level.
Trump also proposed an increase in the current fiscal’s defense budget by $30 billion – $24.9 billion in base budget and $5.1 billion in overseas funds. This also takes into account an additional $3 billion fund for the Department of Homeland Security (DHS) for urgent border protection activities. Without a doubt, approval of these proposals will significantly drive profits for defense companies.
Last month, Trump urged the North Atlantic Treaty Organization or NATO member nations to contribute more to the organization’s defense funds. He expressed his disapproval of how a few nations owe ‘vast sums’ to the U.S. and NATO.
Although Trump’s comments were widely criticized, since U.S. is the largest contributor to NATO (about 72%), his pressure on other members to spend more on defense is expected to increase defense funds for the allied members as a whole. Clearly, defense biggies in the U.S. that generate a substantial share of their revenues from international customers will be direct beneficiaries.
In addition, macroeconomic statistics like improving employment in the private sector, more-or-less stabilized oil price over the past few months, and increasing core consumer price inflation boosted consumer confidence and is being reflected in increased consumer spending. In fact, in Jan 2017, the U.S. personal consumption expenditures (PCE) price index increased 0.4% – the highest since Feb 2013 – after the 0.2% hike in December.
In fact, pinning hopes on Trump’s supply-side economic reforms, economists expect the nation to witness 2.3% growth in 2017 as compared to 1.9% growth last year. Consequently, investors who have been fretting over sluggish growth in the U.S. last year, have regained confidence in the market.
Although rising interest rates continue to be a spoilsport for this sector, its non-cyclical feature helps overcome all oddities.
Picking the Right Stocks is Critical
With the existence of a number of industry players, finding the right stocks that have the potential to beat earnings could be a daunting task. Our proprietary methodology, however, makes it fairly simple for you. You could narrow down the list of choices by looking at stocks that have the combination of a favorable Zacks Rank #1 (Strong Buy), 2 (Buy) or 3 (Hold) and a positive Earnings ESP.
Earnings ESP is our proprietary methodology for determining stocks that have the best chance to surprise with their next earnings announcement. It provides the percentage difference between the Most Accurate estimate and the Zacks Consensus Estimate.
Our research shows that for stocks with this combination, the chance of a positive earnings surprise is as high as 70%.
Let’s take a look at three defense primes that have the right combination of elements to post an earnings beat this quarter:
Huntington Ingalls Industries Inc (NYSE:HII) – Newport News, VA -based Huntington Ingalls is the largest military shipbuilder in the U.S. It designs, builds and maintains nuclear-powered ships such as aircraft carriers and submarines, and non-nuclear ships, such as surface combatants, expeditionary warfare/amphibious assault and coastal defense surface ships. Notably, the company surpassed the Zacks Consensus Estimate in the preceding four quarters, with an average positive earnings surprise of 19.85%.
This Zacks Rank #1 stock has an Earnings ESP of +2.21%. The company is expected to report first-quarter 2017 results on May 4.
Leidos Holdings, Inc. (NYSE:LDOS) – Reston, VA-based Leidos Holdings provides technology and engineering solutions in the defense, intelligence, homeland security, civil, and health markets. Notably, the company surpassed the Zacks Consensus Estimate in the preceding four quarters, with an average positive earnings surprise of 5.80%.
This Zacks Rank #2 stock has an Earnings ESP of +1.28%. The company is expected to report first-quarter 2017 results on May 4.
General Dynamics Corporation (NYSE:GD) – Falls Church, VA-based General Dynamics engages in mission-critical information systems and technologies, land and expeditionary combat vehicles, armaments and munitions, shipbuilding and marine systems, and business aviation. Notably, the company beat the Zacks Consensus Estimate in the preceding four quarters, with an average positive earnings surprise of 5.81%.
This Zacks Rank #3 stock has an Earnings ESP of +0.43%. The company is expected to report first-quarter 2017 results on Apr 26.
The Bottom Line on Defense Stocks: A Top Performing Sector
Defense continues to be one of the top performing sectors owing to its dynamic nature. In the fourth quarter of 2016, the sector’s total earnings grew 13.6% from the same period last year on 2.7% higher revenues.
With none of the companies from this space having released their numbers for this season so far, let us see how this sector performs this time around.
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