Defense investors rejoiced after the November election, sending shares of prime contractors up between 36% and 56% in the months that followed on anticipation that Republican control of the White House and Congress would mean an uptick in spending.
After several false starts, the Pentagon funding picture for the next few years is finally coming into focus. Lawmakers during the first week of February averted a government shutdown, reaching a two-year spending deal that would raise spending caps imposed by the 2011 Budget Control Act by $165 billion for defense in fiscal 2018 and 2019, plus an additional $140 billion allocated for off-budget war funding.
Spending on Lockheed Martin's F-35 fighter is a Pentagon priority. Image source: Lockheed Martin.
The spending plans have a Cold War ring to them, with an emphasis on the United States' need to keep pace with ongoing buildups in Russia and China, along with continuing its counterterrorism efforts. Defense Secretary Jim Mattis told reporters Feb. 11 the Pentagon budget is designed "to bring us back to a position of primacy" while replenishing missile stocks and expanding military capability.
To some extent, the level of certainty that comes with a two-year deal makes the entire industry a winner, because it allows companies to plan accordingly instead of adjusting to ever-changing continuing resolutions every few months. And certainly funding will be flowing into coffers throughout the industry. But even in an expanding budget, priorities have to be established, and some areas are going to come out ahead of others.
Here's why Lockheed Martin (NYSE: LMT), Boeing (NYSE: BA), Northrop Grumman (NYSE: NOC), and Leidos Holdings (NYSE: LDOS) all appear to be among the big winners as defense spending increases, and a word of caution on Huntington Ingalls (NYSE: HII).
Winner: The plane makers
As expected, Lockheed Martin's F-35 Joint Strike Fighter is one of the top priorities coming out of the budgeting process, with the Pentagon setting aside $107 billion to buy 77 of the fighters in the 2019 budget request. Though the fighter has been plagued by delays and the Pentagon in January said the final evaluation process, which is necessary before full-rate production starts, will not begin until late 2018, it's clear this jet is still a major priority for the military.
Another somewhat maligned aircraft, Boeing's KC-46A Pegasus tanker, is also among the winners, with the Air Force requesting $3 billion for 15 of them in 2019. And funding for development of Northrop Grumman's B-21 Raider bomber was increased from $2 billion in 2018 to $2.3 billion in 2019. That number will ease concerns of company execs, and from Air Force officials who in January had warned that absent an increase in funding the B-21 program could be delayed.
There is also an uptick in funding for drones and drone development, including General Atomics' MQ-9 Reaper, a replacement for the older-generation MQ-1 Predator with more capacity to carry a weapons payload and provide more precise close-air support to ground efforts.
Ongoing conflicts have taken their toll on U.S. weapons stockpiles, and the Air Force in the coming years hopes to buy bombs as fast as the industry can produce them to replenish its supplies. The government hopes to purchase more than 48,000 bombs and missiles in fiscal 2019, a 20% increase over the 40,000 to be purchased this year.
Items on the shopping list include Boeing-made guided bombs, Lockheed-designed AGM-114 Hellfire missiles, and small-diameter bombs including a modernized version developed by Raytheon (NYSE: RTN), as well as a range of other rockets and missiles.
Missile defense is also up 25% compared with the last administration's fiscal 2019 projection to $9.9 billion, to be spread across Raytheon, Lockheed, and other contractors. Over the next five years, the Pentagon expects to invest about $47 billion on missile defense, about $14 billion above the last five-year plan estimate.
Winner: Leidos and the Beltway Bandits
When Mattis talks about capabilities, he doesn't just mean advanced weapon systems. Modernizing government IT systems -- and keeping pace on cyber-espionage and other top-secret efforts -- is just as important, yet under sequestration the Pentagon and other agencies were often forced to put tech upgrade efforts on hold. With a new, longer-term budget in hand, a lot of pent-up demand for IT services is ready to be unleashed.
That's probably the scenario General Dynamics (NYSE: GD) was considering when it agreed on Feb. 12 to buy IT specialist CSRA for $9.6 billion, and it should provide support for a range of so-called Beltway Bandits, including Leidos, Booz Allen Hamilton, and CACI International.
While all those companies should be beneficiaries, Leidos, which is among the largest and most diverse pure-play government IT firm, appears particularly well positioned to capitalize and could be among the big winners to emerge from the budgeting process.
Caution: Huntington Ingalls and the shipbuilders
Donald Trump campaigned on the promise of a 355-ship Navy, a massive increase from the current 275-ship fleet and the impetus for shares of shipbuilding specialist Huntington Ingalls to outperform its more diversified contracting rivals since the election. The Navy will grow under the current budget guidelines, perhaps to 300 ships, but the odds it will hit that 355-ship number anytime soon seem remote.
The Navy is requesting $21.9 billion for new ship procurement in 2019 for 10 new vessels, an increase of just one ship over the nine requested in 2018. That's enough to keep shipyards busy making advanced products including two Virginia-class attack subs and three Arleigh Burke destroyers. A commitment to buy one aircraft carrier every five years remains in the long-range plan, keeping the crown jewel of Huntington's Newport News, Va., yard in business.
So while there is no reason to panic over Huntington Ingalls' future, it does appear that the most optimistic hopes for the company were overstated. Management, to its credit, is unlikely to be surprised by this outcome: The company has been forecasting flat revenue through at least 2020.
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