Defense stocks could see 'very favorable' lift from proposed tax reform, says analyst

Key Points
  • Under tax reform, defense companies could see an average earnings per share benefit of 8 to 13 percent, according to Baird Equity Research.
  • Tax overhaul also would provide an incentive for companies to repatriate cash to fund research, buybacks and even potential acquisitions, says Baird.
  • The firm estimates the "potential upside impact" on defense stocks would be an average 8 percent move.
Patriot Missile
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Defense contractors would be large winners from the tax reform packages, with Raytheon and Northrop Grumman among the "top beneficiaries," according to a report issued Monday.

"The impact of the pending corporate tax reform to a 20 percent rate could be very favorable for most aerospace and defense companies within our coverage universe with domestic-oriented defense companies well positioned for higher earnings," said Peter Arment, an industry analyst at Baird Equity Research.

With the lower rate, Baird estimates that defense companies would see an average earnings per share benefit over the 2018-2019 period of 8 to 13 percent. The defense sector on average generates about 76 percent of its revenue domestically.

Arment estimates the "potential upside impact" on defense stocks would be an average 8 percent move, although the report points out Raytheon and Northrop could see even bigger advances and Boeing much less.

Even so, Boeing with a tax rate currently above 30 percent would still benefit from tax reform, Arment wrote. Yet given the commercial aircraft manufacturer's higher international exposure it would see "the smallest" boost among the big defense names, according to report.

At the same time, the analyst said the lower tax rate also would serve as "a strong incentive to repatriate cash to fund R&D efforts, certain program production expansions, general domestic investment and capital redeployment (especially buybacks and M&A)."

The Senate passed its tax overhaul proposal on Saturday after the House earlier approved its own tax reform legislation. A conference committee now is tasked with ironing out differences between the two bills.

Overall, Arment estimates the current average tax rate for the aerospace and defense group is about 28 percent. The analyst sees Northrop and Raytheon as "top beneficiaries" along with a few small-, mid-cap players, including BWX Technologies, Spirit AeroSystems and TransDigm Group.

In October, Raytheon, in updating its 2017 financial outlook, said that its effective tax rate was expected to be about 30 percent. Under tax reform, though, the maker of the Patriot air defense missile system would likely see a lower tax rate in 2018.

Northrop, which is building the Air Force's top-secret B-21 stealth bombers, has an estimated tax rate for 2018 of about 29 percent, but Baird estimates that would shift lower under the tax reform proposals and give the company potentially an EPS benefit of 10 percent.

According to Baird's Arment, BWX and Spirit AeroSystems would be well-positioned to benefit from tax reform by having a high domestic revenue base. He estimates that EPS for the two could be revised upward by more than 10 percent.

Lockheed Martin and General Dynamics, which both average about 27 percent tax rates, could see potential EPS improvements of 7 to 8 percent, Baird estimates.

Baird estimates Boeing's projected tax rate of 32 percent would come down and could end up helping to benefit earnings by about 5 percent.

Similarly, the researcher estimates that Honeywell International and United Technologies would see potential EPS improvements of 4 percent and 6 percent, respectively.

The "less favorable" tax rate cut for Boeing, Honeywell and United Technologies is due to the three large aerospace manufacturers having an average domestic revenue base of about 53 percent, Arment said. However, the analyst said the three aerospace giants would see a "positive" impact on the repatriation rules under tax reform.

"Both UTX an HON have the majority of their cash overseas, which totals $8.5 billion and $10 billion, respectively," the analyst wrote. "HON has also commented that with a favorable change in the repatriation rules [it] would bring all options on the table from major M&A to large share repurchases."