Following piece is written by Rick Whittington, taken from Aerospace And Defense Picks For 2011 (17-12-10). Recently both UK and USA defence budgets were revised with further revision in defence policies. Recent retirement of RAF’s Harrier, and delays in F-35 has created a big gap within RAF inventory. Not only that Both BAe Systems and Rolls Royce has seen declines after recent Qanatas Incident. From civilian market, Seattle Time cites that as Boeing prepares to announce yet another delay for the 787 Dreamliner — at least three months, possibly six or more — the crucial jet program is in even worse shape than it appears. A top Federal Aviation Administration (FAA) official 10 days ago warned Boeing that without further proof of the plane’s reliability, it won’t be certified to fly the long intercontinental routes that airlines expect it to serve. Since then share prices are on continuous decline for Boeing. Among the 787’s lesser ongoing problems is “rain in the plane,” the term used for heavy condensation dripping inside the jet’s composite plastic fuselage. Yet that issue is piddling compared with the major flaws that have brought a wave of successive delays. Earlier this month, John Hickey, the FAA’s deputy associate administrator for aviation safety, visited Seattle and warned 787 executives that in the current state of the program, the jet cannot be certified for long-distance transocean and transpolar flights, according to a person familiar with the details. More on B787 can be found HERE
A fiscally focused trend in U.S. politics means defense spending may drop in 2011. Which aerospace companies will bust and which will boom regardless? Secular change in the U.S. political landscape augurs poorly for defense fundamentals, with fiscal rectitude offsetting China’s brusque ascent on the world scene–an ascent that would otherwise dictate modernization to offset an increasingly sophisticated major power. Following a near decade of above-trend reports, earnings of military suppliers are set for several difficult years, as hard-won margin gains in the Bush years reverse, revenues reduce and backlogs diminish. Just how far the decline will carry remains largely out of public view, as long-range budget details are classified, but Washington circles are already abuzz with steep funding drops in weapons modernization and force structure.
Ongoing budget review, which in Washington goes on all year, is already producing shock waves in contractor circles as word leaks out of the bad news ahead. Actually, many had figured out the deteriorating trend two years ago when a new administration was swept into power, but most held their breath hoping the worst case wouldn’t develop. Unfortunate for the bull case, however, the Republican tidal wave this past election is distinctly tinged with fiscal austerity, with national security taking a back seat. The deleterious impact on defense contractors has finally begun trickling into Wall Street views and the stocks are rolling over.
Pure-play suppliers that have most benefited from the longest conflict in American history–the Revolution’s eight-year employment of Washington’s Continentals has been surpassed by forces in the field in Iraq and Afghanistan–are highly vulnerable to the downsizing that lies ahead. The likes of Lockheed, Northrop-Grumman, Raytheon ( RTN – news – people ), L-3 and General Dynamics ( GD – news – people ) face big funding cuts that seriously compromise earnings integrity and could even create black holes necessitating serious corporate restructuring. Past periods like this have seen steep valuation discounts for the pure-plays.
On the other hand, commercial aviation and industrial infrastructure companies continue to guide up as the business cycle recovery of nearly two years ago gains steam. U.S. business confidence began improving as Congress promised to change hands, meaning additional unfriendly legislation was averted and commerce-centric policies were brought to center stage. Tax cuts will now be followed up with fiscal restraint, incenting hiring and fixed investment projects. Until money measurably tightens, a virtuous cycle encompassing developed world capital goods exporters and consumers will continue to fuel aggregate demand and push earnings higher.
Many think the best plays are in emerging markets, as their growth is much stronger than in far larger, developed economies. Our view, however, turns this consensus perspective on its head, seeing domestic U.S. equities as the preferred plays where they derive principal impetus from global growth. Our favorites include a host of commercial aviation and industrial suppliers that benefit from rising trade flows, demand for aircraft passenger travel and freight. Multi-industry aerospace and industrial companies bring the best of both worlds.
Delay-plagued Boeing ( BA – news – people ) will eventually right the 787 and surmount prior decade outsourcing and partnering decisions that have severely hampered program efficacy. As investors await word on when flight tests will resume and the extent to which deliveries are rescheduled, good news from other quarters is helping offset the latest disappointments. Increased production of other airliner models enjoying strong margins, notably the 777 but also 737 and a re-engineered 747, as well as price hikes combine with ongoing reports of airline profitability and upgraded air traffic forecasts.
Then, there’s also some good news unique to Boeing on the defense front. Overseas sales of fighter aircraft and helicopters to Saudi Arabia and possibly India combine with potentially quite consequential F-35 delays and new generation satellites for both government and commercial customers. As the Chinese build increasingly advanced twin-engine fighters, the U.S. and its Asian allies must confront single-engine, multi-mission F-35s without commensurate aerial superiority. With the F-22 now cancelled and its production base dismantled, there’s no ready response other than more Boeing F-18s. The Navy is already getting extras and we’d guess others will line up behind.
Tag along suppliers to Boeing and Airbus, as well as a handful of business and regional jet makers, include predominantly civil aviation oriented Goodrich ( GR – news – people ), BE Aerospace ( BEAV – news – people ) and Spirit AeroSystems. Spanning a broad gamut of advanced capital goods and industrial materials are diversified suppliers Precision Castparts ( PCP – news – people ), United Technologies ( UTX – news – people ), Honeywell ( HON – news – people ), Eaton and Parker-Hannifin, each a proxy for global infrastructure growth. United Tech and Honeywell just issued bullish 2011 initial views that will likely see upsides as the New Year rolls out.
Then there are companies with greater military exposure, such as electro-mechanical automation supplier Moog, advanced composites supplier Hexcel ( HXL – news – people ) and electronics-denominated navigation, communications and avionics specialist Rockwell-Collins. Each of these should see non-defense segments outweigh prospective cuts in military spending. Other mixed suppliers straddling the two worlds that will have a more difficult time in the years ahead include Esterline, FLIR Systems ( FLIR – news – people ) and AAR Corporation ( AIR – news – people ). These shares could face growing headwinds, especially as U.S. troops begin to draw down in Afghanistan.