Don't Shed a Tear for Defense Firms

12/10/2012 11:15 am EST

Focus: STOCKS

We've heard a lot of bellicose outrage about gutting the US defense sector, but don't worry about it. These defense behemoths will be just fine selling to all the emerging markets looking to build up their defenses, observes John Persinos of Personal Finance.

Put aside overwrought concerns about how the “fiscal cliff” will clobber the defense sector. Demand from rising nations for American know-how in military aerospace will drive profits for top US-based defense contractors, regardless of the budgetary wrangling in Wash­ington, DC.

Post-election overtures on Capitol Hill indicate that Democrats and Re­publicans will probably forge a com­promise and prevent the $500 billion in tax increases and federal spending cuts scheduled for early 2013 that, if allowed to happen, could trigger a recession.

However, in the unlikely event that the dreaded fiscal cliff occurs, US de­fense firms would still remain awash in orders for lucrative big-ticket items.

The US generates more foreign sales of weapons systems than any other nation on Earth. And one of America’s fastest-growing military export niches is aircraft. Fixed-wing combat airplanes account for one third of all global arms transfers, with US-based manu­facturers topping the list of sellers.

Emerging nations are clamoring for US-made combat aircraft that feature highly advanced technology. This demand will more than com­pensate for European belt-tightening or domestic cutbacks.

Several developing countries are girding against age-old antagonists and homegrown dissent. They also view aerospace as a strategic sector that enhances economic competitive­ness; many deals with US contractors entail “offsets,” whereby the manufac­turer agrees to joint production with indigenous businesses.

According to analysts’ consensus, the global military aircraft market was valued at $38 billion in 2011; it’s expected to reach $71.9 billion by 2021, representing a compound annual growth rate of 6.58% during the forecast period. The fastest growth will come from regional “hot spots” engaged in arms races.

Here is a look at one bellwether mili­tary client with strong economies and full procurement coffers. There are a number of these up-and-coming nations that are emblematic of the long-term demand in emerg­ing markets for latest-generation US fighter aircraft.

Also examined are the US compa­nies that stand to benefit the most from these secular trends. Their shares are now attractively priced, largely because of exaggerated fears of a fiscal and monetary impasse in Congress.

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Brazil: Southern Superpower
The Brazilian Air Force is the biggest in Latin America. It oper­ates about 800 aircraft with more than 50,000 personnel. Brazil aims to cement its place as the regional military superpower, with its F-X2 fighter jet program.

Worth $9 billion and designed to replace the air force’s aging fleet of Mirage 2000 and F-5 fighter jets, the F-X2 program picked as one of three fi­nalists the F/A-18 E/F Super Hornet, manufactured by Boeing (BA). Boeing is expected to get the nod, which would be a huge win for the aerospace giant and the tip of the spear for more contracts in Latin America.

The Super Hornet is one of the most popular US aerospace exports, helping drive reliable sales and profits at Boeing. The company posted bet­ter-than-expected results for the third quarter of 2012 and raised its forecast for the full year, as defense orders and commercial aircraft deliveries surged.

Boeing earned $1 billion, or $1.35 in earnings per share (EPS), compared with $1.1 billion, or $1.46 in EPS, a year ago. Third-quarter revenue jumped to $20 billion from $17.7 bil­lion. Analysts had expected Boeing to post EPS of $1.13 for the quarter.

Defense stocks sport a price-to-earnings ratio (P/E) of 10, com­pared to the broader market’s P/E of 11. Boeing’s P/E is about 12, an attractive price in light of its growth prospects.

A major avionics and electron­ics supplier for the Super Hornet is pick Honeywell International (HON), which recently raised its full-year 2012 outlook, as growth in the US and emerging markets counterbalanced weakening conditions in Europe.

Based in Morris Township, New Jersey, Honeywell is diversified in the aerospace, automotive, chemicals, health care, housing, and agricultural sectors. Honeywell’s aerospace divi­sion, responsible for about 11% of total revenue, is enjoying a tailwind as an improving global economy lifts commercial aircraft purchases.

The company reported third-quar­ter revenue of $9.34 billion, up 0.5% from the same year-ago quar­ter. EPS rose 38% to $1.20, beating analysts’ consensus of $1.14.

With a P/E of 20.5, the stock’s valuation exceeds that of its sector (industrial goods, at 15.3) and of its defense brethren. However, it’s a fair price considering its solid prospects in both defense and commercial markets.

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