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Stock Analyst Update

Awaiting Defense Spending Changes for Contractor Stocks

We believe it is worthwhile to reconsider the effects of the war on global defense budgets and defense prime contractor valuations

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As the Russian military is conducting significant military operations throughout Ukraine, we believe it is worthwhile to reconsider the effects of the war on global defense budgets and the subsequent effects on defense prime contractor valuations. As of Feb. 28, the German Chancellor Olaf Scholz announced that Germany would increase defense spending from roughly 1.5% of GDP to over 2% of GDP and the Japanese Ministry of Defense announced in November that Japan’s fiscal 2022 defense budget would rise to about 1.14% of GDP, which would be the first time since the 1960s that Japanese defense spending exceeded 1% of GDP. Despite the increases in defense budgets, we are maintaining our valuations across our North American prime contractor coverage as we await news from Washington on defense spending for fiscal 2023. This noted, we would expect that the military operations will encourage more spending that would buoy the justified valuations of prime contractors, so we think the risks to our valuations skew to the upside. Valuation-wise, our preferred names within our defense prime coverage are Lockheed Martin (LMT) and Huntington Ingalls (HII).

We think waiting to update our valuations is prudent because the domestic market remains by far the most important market for defense prime contractors. Most U.S.-based defense primes have about 10%-30% top-line exposure to international customers, with Lockheed Martin and Raytheon Technologies (RTX) having relatively more international defense exposure and Huntington Ingalls, Northrop Grumman (NOC), and General Dynamics (GD) having relatively lower levels of international defense exposure. Procurement accounts tend to be the most cyclical defense budget account, so changes in defense spending have an outsized impact on procurement. Still, a large increase in these nations’ defense budgets seems unlikely to us to drive more than a 5% change in any contractor’s top line.

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Burkett Huey does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.