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