The Islamic State of Iraq and Syria (ISIS) has gathered more power over the past few years, flaring up radical Islamic terror attacks across the globe. While President Obama never really discouraged the nation’s defense expenses, President Trump has been criticizing his predecessor’s budget sequestration decision taken in 2013; particularly with respect to the defense frontier.
Moreover, with his recent fiscal 2018 budget proposal of a record 10% hike in defense spending, President Trump looks to wage a “War on Terror,” in line with commitments he made during his campaigns as well as from the very first day of his tenure. Undoubtedly, such a hike is expected to usher in a ‘golden era’ for stocks in the aerospace and defense industry; thereby attracting more investors to them.
In addition, widespread macroeconomic as well as geo-political uncertainty has pushed up demand for weapons in recent times. With the U.S. being the largest supplier of the world’s most-advanced weaponries, emergent global security threats force allied nations to turn to it for defense aid as well as buy state-of-the art ammunitions. Naturally, these are giving a boost to the Aerospace sector as a whole.
As expected, the U.S. remains atop all nations when it comes to military expenditure. Notably, military spending consumes more than 50% of the U.S. discretionary budget, way ahead of the second-spot occupant China and third, Russia.
Many of the defense majors in the nation are doing a decent job, propelled by the following strategies:
Recent Uptrend in Budget: On Mar 16, 2017, along with the fiscal 2018 (FY 2018) budget proposal, the Trump administration also put forward a request for additional FY 2017 appropriations. Under additional appropriations, the White House requested an extra base budget of $24.9 billion and Overseas Contingency Operations (OCO) budget worth $5.1 billion; taking total budget appropriation to $30 billion for FY 2017. This amended request also calls for a hike of more than 26,000 active military forces from the original FY 2017 request and more than 6,000 forces from FY 2016’s actual force strength.
In addition, these appropriations support future investment capabilities worth $15.5 billion in the aerospace and defense industry to improve the nation’s near-term and mid-term combat promptness to counter threats. Of this amount, $4.6 billion has been allotted for Army, $5.8 billion for Navy, $4.1 billion for Air Force and $1 billion for defense-wide spending.
Moreover, the proposed base budget appropriations of Mar 2017 seek to invest $13.5 billion in procuring additional and modernizing Army Apache and Blackhawk helicopters, F-35 and F/A-18 fighter aircraft, tactical missiles, unmanned aircraft systems, and Terminal High Altitude Area Defense interceptors. No doubt such spending will boost the business of defense biggies, in particular The Boeing Company (BA) and Lockheed Martin (LMT) that manufacture these defense equipment.
The FY 2017 budget request released by the Obama government had revealed plans to adjust the size of the force over the next several years to a level of 980,000 soldiers, 308 ships, 182,000 active-duty Marines and 55 Air Force tactical fighter squadrons. This indicated a likely expansion strategy in the U.S. military force. Now, with President Trump being highly in favor of defense spending, these numbers have a huge chance of getting elevated in the coming days.
Foreign Military Sales (FMS): Big defense operators in the U.S. are expanding their markets rapidly, with foreign sales acting as a key top-line growth driver. Political conflicts and regional tensions have been driving demand for foreign sales, particularly in the Middle East with the ongoing military clash between two political parties in Iran since last year and Saudi Arabia’s alleged role in it, the Syrian civil war, the unrest in Iraq, Yemen and Libya, and a coup operation conducted in Turkey last July.
Developed nations of Europe have also failed to escape the scythe of terror. The Paris attack of Nov 2015 took 130 lives and a series of terror threats that followed affected citizens of Brussels, Berlin, Normandy and the most recent in London. Moreover, with no regional arms control regulation in place, the emerging nations in Asia such as India and Japan are continuing to boost their arsenal. U.S. being the top global arms exporter is seeing added arms import by these foreign countries. This is giving U.S. aerospace and defense business a big boost.
Of the recently made FMS deals, worth mentioning is the $3.3 billion modification contract that Boeing clinched last month from the U.S. Army for supplying lot 7-11 of AH-64E Apache attack helicopters to the government of Saudi Arabia. Work related to this multi-year deal is expected to be over by Jun 30, 2022. In February, Raytheon Company (RTN) secured an FMS deal worth $1.1 billion from the U.S. Air Force. Under the terms of the deal, the company will provide an early warning radar system to the Qatar government, which will be incorporated into the nation’s integrated air and missile defense enterprise.
There were doubts in relation to Trump’s foreign defense policies when he attained presidency as repeatedly referred to insufficient contributions from many alliance partners during his campaign. However, over past few months, the U.S. situation in terms of FMS deals seems to have only improved.
Restructuring/Acquisition: To maintain margins in a tough business environment, companies are squeezing costs out of their operations and diversifying into new business areas. Commercial aviation is one such diversification play, with opportunities in emerging markets driving the trend.
New macro challenges are prompting industry players to revisit their business models. One such example is the recently completed takeover of Implant Sciences’ explosives trace detection (ETD) assets by L3 Technologies, Inc. (LLL) for $117 million. These assets will help L3 Technologies increase its capabilities in the global aviation security and national security markets by offering domain expertise and technical capabilities that Implant Sciences has in innovative tracing solutions, apart from boosting L3 Technologies’ sensor portfolio.
In February, premium engineered aircraft components provider TransDigm Group Inc. (TDG) acquired SCHROTH Safety Products GmbH and aviation & defense assets and liabilities of Takata Corporation for a total of $90 million. With the acquired assets, the company will focus on designing and manufacturing proprietary, highly engineered, advanced safety systems for aviation, racing, and military ground vehicles.
Increase in Cyber Spending: Computer attacks are among the most pressing security challenges facing the U.S. Increasing cyber-attacks, terrorism threats, and enhanced geopolitical instability are pushing focus toward electronic warfare, C4ISR (Command, Control, Communication, Computers, Intelligence, Surveillance and Reconnaissance) and cyber security. In this context, the FY 2017 appropriation budget request includes funding worth $7.2 billion for operations and maintenance to address urgent readiness shortfalls across the joint force, including improvements in cyber intelligence capabilities.
Moreover, Trump’s proposed FY 2018 budget allocates $1.5 billion for Homeland Security to tackle cyber attacks, including protecting critical infrastructure.
The Trump Factor: Although a few of his controversial remarks initially forced some analysts to worry over the nation’s defense stocks, the ultimate result has been an encouraging message to the industry from President Trump so far. A few instances will make this point clear.
Throughout Dec 2016, Trump slammed Lockheed Martin calling its F-35 program an ‘out of cost’ project. However, F-35 is the world’s largest defense program and accounts for a major share of revenues for Lockheed Martin. Trump also criticized Boeing for developing a highly expensive version of the Air Force One – the President’s carrier – and urged the federal government to cancel its order with Boeing for the jets. Naturally, such allegations caused the defense stocks to tumble initially.
However, in Feb 2017, Trump stated that after a month of negotiation with Lockheed Martin Corporation (NYSE:LMT), he has finally induced a feasible cost cut of $600 million for the 10th Lot of F-35 jets. Last month, Lockheed’s CEO Hewson admitted that President Trump’s insistence in cutting cost of F-35 did have a major influence on this program’s cost-saving initiative. Management now plans to reduce $85 million or less per plane by 2019. This is in sync with Trump’s belief that that the cost reduction initiative will save “billions and billions of dollars” for the U.S. government.
Moreover recently, Trump urged his fellow North Atlantic Treaty Organization or NATO member nations to contribute more to the organization’s defense fund. He expressed his disapproval of how a few nations including Germany owe ‘vast sums’ to the U.S. and NATO, and described the situation as a ‘very unfair’ one, especially for his country.
Although Trump’s comments were widely criticized, since U.S. is the largest contributor to NATO (about 72%), Trump’s pressure on other members to spend more on defense is expected to increase defense funds for the allied members as a whole. Clearly, defense biggies in the U.S. that generate a substantial share of their revenues from international customers will be the direct beneficiaries of the situation.
Last week, the Trump administration announced plans to pursue the $5 billion sale of 19 Lockheed Martin F-16 jets to Bahrain that got stalled owing to human rights’ concerns last year by the Obama administration. As told to Congress, the U.S. State Department will reinstate the deal, putting aside human rights’ conditions imposed by the Obama government. Though the Bahrain deal has crossed the primary hurdle, the entire process involves many more stages.
Nevertheless, given that Bahrain is one of the nation’s valued customers, the deal will surely give a big boost Lockheed Martin’s business prospects.
Here is whom we consider some of winners in this new era of defense and technology spending…
Defense Stocks to Consider
Considering the aforementioned drivers of the defense stocks and the fact that budget sequestration will mostly fail to survive under Trump’s administration, we are bullish on Huntington Ingalls Industries Inc (NYSE:HII), sporting a Zacks Rank #1 (Strong Buy).
We are also positive on stocks like Leidos Holdings, Inc. (NYSE:LDOS) and Lockheed Martin; both of them carry a Zacks Rank #2 (Buy).
The Bottom Line: Defense Spending is Non-Cyclical and Investors Should Look to Profit
Macroeconomic factors in the U.S. are currently favorable for economic growth. In the words of Fed Chairperson Janet Yellen, the central bank has “confidence in the robustness of the economy and its resilience to shocks.” So investing in a non-cyclical sector, like defense, particularly its attractive stocks, looks to be a good idea now.
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