The importance of the aerospace & defense industry stems from the strategic role it plays in the country’s security. As threats turn into ever new shapes involving asymmetric, air-sea power, cyber, urban, non-state organizations, and many more, the defense capabilities of a country need to morph accordingly to contain them.

The recovering U.S. economy and elevated geopolitical risk appear to be fueling support in Washington for an increase in fiscal 2016 defense spending above sequestration caps. The U.S. economy picked up pace in the second quarter after a soft start in the first. According to the “advance” estimate by the Bureau of Economic Analysis, second quarter GDP increased at a rate of 2.3%, which was more than the revised 0.6% growth in the first quarter. However, national defense spending declined 1.5% in the quarter compared with an increase of 1% in Q1.

Nevertheless, the slowdown is likely to be short-lived given the enormous tailwind from a sharp plunge in energy costs encouraging Americans to spend. The improving job market and the boon to households from low inflation alongside falling oil prices have been key to the economy’s ability to sustain strong growth. This positive economic picture is likely to have a favorable influence on budget allocations.

This industry has emerged relatively unscathed due to fleet renewals at airlines worldwide with more fuel efficient aircraft, a growing international market and increasing application of unmanned aircraft in warfare today. Furthermore, rising threats from the Islamic State in Iraq and Syria (ISIS, or ISIL) saw an increase in U.S. defense expenditure.

Budget Updates

President Obama’s fiscal 2016 budget proposal, unveiled on Feb 2, 2015, called for $3.99 trillion in spending for the fiscal year beginning Oct 1. This is a 6.4% increase from the current year budget. Of this, the Obama administration wants $534.3 billion to be allocated for the Department of Defense’s (DoD) base budget and $50.9 billion in war funds, a total of $585.3 billion. The base budget proposal is about $38 billion more than what sequestration would allow and over the FY2015 enacted budget of $496.1 billion.

In contrast, the Republican-controlled Senate approved its version on Mar 2015 of the GOP fiscal 2016 budget. The plan suggests spending almost $3.8 trillion in fiscal 2016 overall. The budget keeps military spending at $523 billion, the level set by the caps. It also allots about $90 billion for Pentagon’s separate war fund, the overseas contingency operations (“OCO”) fund. It is worth noting that OCO is not subject to the automatic budget caps imposed by sequestration.

Zacks Industry Rank

The Zacks Industry Rank relies on the same estimate revisions methodology that drives the Zacks Rank for stocks. The way to look at the complete list of 260+ industries is that the outlook for the top one-third of the list (Zacks Industry Rank of #88 and lower) is positive, the middle 1/3rd or industries with Zacks Industry Rank between #89 and #176 is neutral while the outlook for the bottom one-third (Zacks Industry Rank #177 and higher) is negative.

The aerospace industry is one of the 16 broad Zacks sectors within the Zacks Industry classification. Within the Zacks Industry classification, aerospace is further sub-divided into three industries at the expanded level: aerospace/defense, aerospace/defense equipment and electric-military.

Aerospace/defense is neutral with a Zacks Industry Rank #108. Aerospace/defense equipment with a Zacks Industry Rank #175 comes in the middle one-third or in the neutral zone of all Zacks industries. The Zacks Industry Rank for Electric-military is however at #228 out of 260 industries, which puts it in a negative zone.

Hence, investors should be a little cautious of the Electric-Military sub-industry.

Earnings Review and Outlook

The defense sector has drawn the curtain on the Q2 earnings season with impressive earnings as well as revenue beat ratios (percentage of companies coming out with positive surprises) of 77.8% and 55.6%, respectively.

However, the quarter tells a story of lower earrings as well as margins. The top contractors -- Lockheed Martin (LMT - Analyst Report), General Dynamics (GD -Analyst Report), Textron (TXT - Analyst Report) and Northrop Grumman Corporation (NOC - Analyst Report), were nonetheless spared. A combination of cost-cutting, stock buybacks and earnings gains from businesses outside the federal market helped to minimize the pain for investors.

The picture is somewhat still gloomy as the aerospace sector’s earnings are expected to decline at 7.7% in the third quarter, though slightly better than Q2. The sector is expected to register top-line growth of 0.9% (versus 4.6% growth in Q2) while margins will move north to 6.9% (versus 6.8% growth in Q2).

For the S&P 500, earnings are expected to decline at a rate of 5.1% and revenues will likely take a hit of 4.7% in the third quarter.

To Sum Up

Despite the contending budgets discussed above, the wind is definitely in favor of boosts to the defense budget, as the Pentagon has hitherto been mostly strained, monetarily and otherwise, with the threat to homeland security the top concern.