FBR Capital Markets expects the S&P's downgrade of the United States' debt will actually have a more negative impact on the commercial aerospace names as compared with its defense names.

"We do anticipate that both will go lower with the news, since the timing was unexpected," said Patrick McCarthy, an analyst at FBR Capital.

Defense Impact

For defense stocks, McCarthy believes the initial reaction is to trade the group down under the assumption that the ratings downgrade will increase the call for additional defense spending cuts above what is already anticipated.

However, after the market digests that point of view, McCarthy thinks it will come to the conclusion that this downgrade ratchets up the heat on the super committee to identify the $1.2 trillion in additional government-wide funding cuts, which would be incrementally positive for defense stocks, since it would cap the DOD's contribution in the mid-$300.0 billion range over 10 years.

At the current time, McCarthy thinks the market is anticipating a defense budget cut of closer to $500 billion to $600 billion over 10 years, so bringing the consensus back to $350 billion would be an incremental positive in what is admittedly a challenging environment.

McCarthy said the more immediate, 2011 impact, is likely to be on how defense companies alter their capital allocation strategies. After a decade of higher defense spending and improved profitability, defense companies are cash rich.

As McCarthy head into an environment of slower defense spending, companies have been aggressively buying back stock and paying dividends. In fact, from all of the major defense companies, he has seen a trend of increasing their buybacks and aggressively increasing their dividends.

As a result, the incremental buyer of defense stocks over the past two years have been those investors looking for high cash flow generating companies that are willing to return it to investors (through buybacks) and have an attractive yield.

However, if CFO's act liked they did in 2008 and early 2009, McCarthy would expect them to become incrementally more cautious in returning cash to shareholders as they cautiously take care of the balance sheet.

"Why might they not? So far, from everything that we have read, the S&P downgrade is not expected to create a liquidity crisis like we saw in 2008. As a result, CFO's might be more willing to maintain the cash allocation status quo," said McCarthy.

Commercial Aerospace Impact

Over the past two weeks, McCarthy believes the market has been thinking more and more about the potential for the U.S. economy to go back into a recession and he has seen that in the group's performance.

Given the more intense pressure to pull government spending down even more, McCarthy believes it is likely that the market increases the probability that this downgrade moves us closer to another recession, which would be negative for commercial aerospace stocks.

That, combined with the U.S.'s already anemic job growth, make the prospect of even lower government spending an incremental negative for the group.

During the 2009 recession, airline industry revenues were forecasted to drop anywhere from 12 percent to 15 percent or $62 billion. By comparison, in the air travel decline after the September 11 attack, industry revenues fell by 6 percent to 7 percent or $23 billion.

In McCarthy's view, another recession due to the debt situation could affect industry revenues by 7 percent to 9 percent, which would be highly detrimental to airline profitability.

As a result, McCarthy would expect a similar situation to unfold as in the last two recession where airlines defer original equipment manufacture (OEM) orders and other discretionary spending on aircraft like interiors and upgrades.

McCarthy said OEM suppliers will see production lines slow down and their inventory build as the OEMs, due to deferral of orders, will not take delivery of parts and other input materials.

In addition, airlines will likely go back to keep inventories very low and destock existing inventory. This trend, as McCarthy has seen in the past, is negative for those names leveraged to the aftermarket.

In the latest recession, McCarthy saw most of the commercial aerospace names trade towards historical low multiples as both consumer and business travel declined dramatically.

In McCarthy's view, the market will likely take a more draconian view to the S&P downgrade and its impact on commercial aerospace names.

"We expect the group to be weak as off the news and it could be a month or two before we see any meaningful impact to air travel, which will be reported by IATA towards the end of the month," said McCarthy.

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