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Defense Stocks in the Trump Era

Date: March 15, 2017      Publication: Bottom Line Personal      Source:  Richard Safran, Buckingham Research Group      Print:

What will the Trump administration’s defense policies mean for stock investors? That’s what Wall Street has been trying to figure out since Donald Trump was elected president. Trump has put tremendous pressure on the ­defense industry to reduce what it charges the government and has said that the US should spend less money defending other countries. But he also has said that he would beef up the military, quickly destroy ISIS and end military spending caps imposed by Congress in 2011—all of which suggest more military spending, not less.

Bottom Line Personal asked defense-stock expert Richard Safran what all these seemingly conflicting factors mean for defense-industry investors and which companies stand to be hurt or do best in the coming years…

The Global Arms BuildUp

Escalating global threats and Trump’s likely responses to them mean that a massive surge in defense spending is likely. Even though many defense stocks have already risen based on this outlook, defense manufacturing still could be one of the most profitable sectors for investors over the next few years.

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The last time the federal government “spent big” on defense was back in the 1990s, but a lot of weapons and equipment were never replenished—the US still operates trainer jets and bombers from the 1960s and fighter jets from the 1970s. The 2003 Iraq invasion only exacerbated the problem by putting more wear and tear on the equipment. And since 2011, the defense budget has barely grown at all, severely ­restricted due to spending caps in Congress known as sequestration.

Trump is pushing for the US to spend an additional $50 billion to $60 ­billion a year to replace aging equipment and roll out next-generation weapons to maintain technological superiority over rival militaries in countries such as ­China and Russia. The Pentagon is likely to get permission for those spending increases because, I believe, the Republican majorities in Congress will repeal or alter the 2011 spending caps.

At the same time, US defense manufacturers will see improved profits from rising international sales. For example, American ­allies in the Middle East such as Saudi Arabia, the United Arab Emirates and Israel are buying more jet fighters and missiles. And last year, the US government lifted a 40-year arms embargo on Vietnam, which is seeking to defend its claims in the South China Sea against challenges from China.

Below are four areas of the defense industry I think will benefit the most from US and foreign government spending…

Submarines and Surface Ships

Trump and the Pentagon intend to ­expand the Navy’s fleet of 272 vessels to 350, about the same number that China expects to have by 2020. Reaching that number could add $10 billion a year to the current Navy budget with an emphasis on attack submarines and destroyers. My favorite stock…

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• General Dynamics Corp. (GD), with about $32 billion in annual revenue, is the nation’s largest shipbuilder. It also manufactures ground-combat ­armored vehicles and Gulfstream business jets. And it has a backlog of more than $60 billion in orders, which should fuel multiyear revenue growth. It is carrying out a $3.4 billion Navy contract for five ­Arleigh Burke–class destroyers, which have the most advanced air and missile-defense radar in the fleet, as well as an $18 billion contract for 10 Virginia-class nuclear-powered fast-­attack submarines with stealth capabilities.

Military Aircraft

In late 2015, Congress passed a law requiring the Air Force to have a total of at least 1,900 fighter jets, in part to maintain air superiority over China’s and Russia’s squadrons. Trump plans to increase Air Force funding by $7 billion to $8 billion a year. My favorite stock…

• Lockheed Martin Corp. (LMT) is the world’s largest defense contractor, with $45 billion a year in revenue and a vast military catalog ranging from mobile rocket launchers to nuclear ballistic missiles to UH-60 Black Hawk helicopters. But the company’s flagship program, which accounts for 20% of annual revenue, is the nearly $400 ­billion, multidecade agreement to supply more than 2,400 stealth F-35 fighter jets, the world’s most technically advanced jet in production, for the Air Force, Navy and Marines. Hundreds more F-35s have been ordered by allies such as Australia, Japan and the UK. Trump chastised Lockheed Martin for cost overruns on the production of F-35s, threatening to cancel the contract, and asked competitor Boeing to look at an upgrade to its existing F/A-18 jet. However, it would take years for Boeing to develop a fighter comparable to the F-35—and it might not even be possible—so it’s very unlikely that Lockheed will lose the contract or even that the price per jet will drop enough to materially hurt company profits.

Cyber Defense

Cyber is one of the fastest-growing ­areas of defense as the US seeks to protect computer networks against foreign governments and individual hackers. The 2017 Pentagon budget is expected to allot $19 billion for software and services, a 35% increase from 2016. I expect double-digit annual increases in funding over the next several years. Trump signaled that cyber defense is a priority by appointing Thomas Bossert, who helped draft the US government’s first-ever ­cybersecurity strategy during the George W. Bush administration, as assistant to the president for homeland security and counterterrorism. My favorite stock…

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• Raytheon Co. (RTN) has annual revenue of $23 billion and back orders for its Patriot missile-defense systems and precision weapons totaling $37 billion. But Raytheon’s cyber-defense business may see the most rapid expansion in the next decade. Last year, the US Department of Homeland Security awarded Raytheon a $1 billion contract to protect the computer networks of more than 100 federal ­civilian agencies. The company also has won recent contracts from the Defense Advanced Research Projects Agency (DARPA) to detect and respond to cyberattacks on the US power-grid infrastructure and from the US Navy to provide cyber-defense software simulation and training.

Surveillance and Reconnaissance

Spy equipment ranges from satellites and sensors to aircraft and electronics to enable advanced navigation, communication, targeting and detection. My favorite stock…

• L3 Technologies (LLL) is a subcontractor that enhances weaponry for multiple defense manufacturers. Its products range from software that relays information from unmanned surveillance planes to troops on the ground…to cockpit display systems used in F-35 fighter jets. Recent deals include a $238 million contract with the US Navy to install sonar receivers on submarines and a $500 million Army contract to provide satellite-communications support services. L-3, which has annual revenue of more than $10 billion, also has a commercial division that makes security-screening equipment for airports.

Source: Richard Safran, director and partner specializing in defense stocks at Buckingham Research Group, an equity research firm, New York City. Formerly, he was a defense analyst at Goldman Sachs and an aerospace engineer working on stealth technology. BuckResearch.com