Government appropriations are poised for growth, some analysts say, and domestic orders look promising.
Patrick J. McCarthy
Friedman, Billings, Ramsey & Co.
Areas of Coverage: Commercial Aerospace & Defense
Outlook for Defense: In 2006, large-cap defense was the stalwart performer, solidly outperforming mid- and small-cap peers. Attracted to the group’s excellent visibility, tremendous free cash flow generation, and massive buyback programs, investors flocked to the space, and with good reason. The critical questions now are whether the performance of the large-cap group can persist into 2007 and whether small- and mid-cap laggards can bring back the stellar performances they posted just a couple of years ago. In our view, the answer to both questions is yes, and to understand why, one needs only to look at the budget.
The fiscal year ’07 defense budget appropriation of $440.3 billion was essentially flat with the fiscal year ’06 submission. However, with another $70.0 billion appropriated by Congress in the form of bridge funding and another $100.0 billion requested by the Department of Defense (DOD) through supplemental funding, total ’07 appropriations were closer to $610.0 billion, representing almost 9.5 percent growth over ’06. The mix in funding highlights a positive trend for defense contractors as well.
In the ’06 budget, the procurement account (which funds the majority of the industry’s high-margin, high-volume production revenues) declined by approximately 2.5 percent (excluding supplemental funding). In the ’07 budget (active), the procurement account has been budgeted for 10.5 percent growth, which easily supports another year of mid- to upper-single-digit growth for defense contractors, in our opinion. This, in turn, should enable another year of margin expansion (although probably at a declining rate) and tremendous free cash flow generation.
Additionally, based on the DOD’s Future Years Defense Plan, Office of the Secretary of Defense guidance to the service branches, and encouraging data from the Office of Management and Budget, we also believe that the fiscal year ’08 budget, which will be submitted in February 2007, will be better than current expectations. Based on a number of factors, we believe that total appropriations (including bridge and supplemental funding) for ’08 will approach $675.0 billion, representing growth of almost 10.5 percent. All in all, a nice backdrop for investing in the industry.
Outlook for Commercial Aerospace: We believe that we are in the early stages of a commercial aerospace up-cycle that will peak in 2010. Until that time, we expect solid demand for air travel to drive new aircraft orders and increases in overall capacity that in turn will stoke the high-margin aftermarket.
We continue to believe that the Asia-Pacific region will be a major contributor to this growth, due to the strength of its economic outlook and the more profitable profile of its carriers than legacy North American peers. Additionally, we believe that the region’s growing middle class will increase the frequency with which it travels. In general, the emerging economies of the Asia-Pacific region, as well as India and the Middle East, should show very strong growth during the coming years, with the mature North American and European markets remaining stable.
Outperform: B/E Aerospace (BEAV); Goodrich Corp. (GR); Ladish Co. (LDSH)
Top Pick: B/E Aerospace
Why B/E Aerospace? B/E Aerospace reported 4Q06 results that exceeded expectations for both revenues and EPS. Revenues and EPS for the quarter were $321.6 million and $0.28 versus the consensus estimate of $299.0 million and $0.26, respectively. The company also established EPS guidance for 2007, 2008, and 2009 that is higher than the current consensus. Based on the better than expected outlook for the next three years, we are raising our price target on the company from $33 to $37 and reiterating our Outperform rating.
Troy J. Lahr
Stifel, Nicolaus & Company
Areas of Coverage: Commercial Aerospace & Defense
Outlook for Commercial Aerospace: Commercial airline orders at Boeing and Airbus were strong in 2005 and 2006; however, U.S. airlines did not fully participate in the order rally as they have historically. Domestic orders accounted for approximately 25 percent of 2005-2006 worldwide orders compared to the 50-year average of 50 percent. As a result, we would expect domestic orders to increase in 2007-2008 and expect approximately 9,200 orders through 2010.
We believe the rebound in domestic orders will likely be driven by four key factors: one, aging airline fleet — approximately one-third of the U.S. airline fleet has an average age of 19 years; two, the need for fuel-efficient aircraft — in our view, with high fuel costs airlines need more fuel efficient aircraft, some of which could provide a 20 percent-30 percent cost savings advantage; three, airlines improving financially — revenue, income and cash have grown significantly with added pricing and utilization; and, four, a recovering economy supporting air traffic growth absorbs excess capacity, causing pricing to improve.
Outlook for Defense: U.S. defense companies benefited from steadily rising defense spending driven by: one, increasing global threats (terrorism, rogue states and modernizing conventional forces); and, two, the need to transform and modernize to adapt to the current post-Cold War environment.
Historically, defense spending is highly correlated to threat levels, and we believe the threat environment remains high. As a result, we expect continued growth in defense spending (at least through 2009). In our opinion, there is some budgetary flexibility for continued growth in defense spending, as government revenue growth exceeds outlay (spending) growth — resulting in a reducing deficit. Nevertheless, we believe many defense companies are trading at appropriate valuation levels, and therefore we have a neutral stance on the industry.
Buys: K&F Industries (KFI), Orbital Sciences (ORB), Raytheon (RTN)
Top Picks: B/E Aerospace (BEAV); Boeing (BA)
Why Boeing? We believe Boeing shares currently offer investors an attractive investment opportunity due to improving operating margins, higher aircraft deliveries, a very competitive product portfolio, rising ROIC and strong free cash generation. In our opinion, 2005 was the first year of a six- to seven-year order cycle that should lead to steady delivery growth at least through 2013. As a result, we anticipate strong margin improvement to result from restructuring during the prior downturn. The defense segment at Boeing is also winning new business and surprising industry competitors with low-cost, low-risk solutions. For the first-time in a long while, Boeing appears to be firing on all cylinders. Our target price is $102.
Why B/E Aerospace? B/E Aerospace is a leading manufacturer of aircraft interiors (seats, food/beverage equipment, oxygen equipment) for commercial aircraft and regional and business jets with most market share positions averaging 50 percent. We anticipate end-market demand to increase approximately 20 percent annually through 2008. B/E operating margins are expected to increase significantly through 2009 on higher volumes, a favorable product mix, previous restructuring efforts and lower research costs. Therefore, given the potential for strong top-line growth and significant margin improvement, we believe B/E is capable of 25 percent growing earnings over the next five years. Our target price is $39.
Area of Coverage: Commercial Aerospace & Defense
Strong Buys: EDO Corp. (EDO); Harris Corp (HRS); KVH Industries (KVHI)
Outperform: HEICO (HEI); Teledyne Tech (TDY)
Comments on EDO: [On Dec. 5, 2006] the Naval Sea Systems Command (NAVSEA) issued a pre-solicitation notice naming five contractors qualified to compete on the CREW 2.1 spiral contract to procure up to 10,000 Vehicle- Mounted Counter Radio-Controlled IEDs (i.e. bomb jammers) with an estimated contract value of $500+ million. Both EDO’s Communications & Countermeasure business (located in Thousand Oaks, Calif.) and the company’s recently-acquired Impact Science & Technology business were cited as “…among the only [companies] capable of satisfying the government’s requirements,” in this limited competition procurement (contracted on an “unusual and compelling urgency basis”).
We are currently forecasting sales of $33 million in 2007, but EDO’s participation on the 2.1 spiral could radically alter the company’s outlook (EBIT margins are likely to be two times the corporate average).
Although EDO’s participation in this contract is by no means assured, the company’s odds appear pretty good. Further, with the stock trading at only about 12.6 times the consensus 2007 EPS estimate of $1.72 (vs. the industry median of 18.8 times), it would be hard to argue that this opportunity is fairly priced into the stock.