Spotlight on Aerospace / Defense Sector: 3 Investment Candidates

After a six-year run of improving performance, resulting in a composite industry share price performance approximately three times better than the S&P 500 Index, the U.S. aerospace and defense industry finds itself in transition and facing uncertainty and, perhaps, leaner times ahead.

With core defense spending expected to slow, U.S. defense contractors need to identify additional revenue sources for the coming years. The near term should see some interesting merger and acquisition activity, mostly smaller deals by larger contractors to fill in capability gaps - particularly in the security, defense electronics and aftermarket service business areas.

Taking the uncertainty of current economic conditions into consideration, it is difficult to predict overall aerospace industry performance in the near term. In the longer term, however, prospects are good for continued, steady growth. Large civil aircraft, rotocraft, general aviation aircraft, regional and business jets, engines / power plants, communications satellites, military unmanned aerial systems and airport infrastructure and safety equipment should continue to experience steady growth. Other sectors, such as launch services, are experiencing lower but steady growth as they recover from market disruptions and / or adapt to commercial markets. The launch services sector could experience faster growth if the demand for satellite telecommunications services increases.

The maintenance, repair and overhaul [MRO] market has finally recovered to pre-9/11 levels, and growth in this sector will be led by expanding aircraft fleets in India, Eastern Europe, South America and China. The market for civil / commercial unmanned aerial systems remains stagnant in the absence of the civil regulations for certification and operation in the national air space; however, the Federal Aviation Administration and civil aviation authorities in Europe and Asia are working towards rationalization of civil certification procedures. Key markets for U.S. aerospace exports remain India, China, Russia, Japan, and Europe.

In summary, the overall level of defense spending will trend downward in response to unfocused threats, big budget deficits, a weak economy and an ambition domestic agenda. The business outlook for second-tier defense companies that grew rapidly during the Bush years will weaken as larger companies invade their market turf in pursuit of a more diverse business mix, leading a wave of consolidation in the sector that eliminates many smaller companies.

Our database categorizes 78 companies as being part of the aerospace and defense industry. Our screening criteria looks for companies with a healthy balance sheet, not too much debt and ROI and CFROI of at least 10%. This screen brings the number of candidates eligible for closer examination down to three: AeroVironment (AVAV), Cubic Corporation (CUB), and Force Protection (FRPT).

Our recommendation is to hold AVAV, sell CUB and hold FRPT.