Our Long-Term Thesis on Defense Contractors Is Intact
We expect defense names to move upward over the short- to mid-term and outperform the market.
Donald Trump won the U.S. presidential election last night and Republicans are set to maintain control of the Senate and House. We expect defense names to move upward over the short- to mid-term and outperform the market. We anticipate investors will view pure play defense names like Raytheon, (RTN) Lockheed Martin, (LMT) L-3, (LLL) and Northrop Grumman, (NOC) as safer investments within a turbulent market. General Dynamics (GD) should also outperform. However, its business jet segment (27% of total revenue but 41% of operating profits) dilutes its defense exposure. Boeing may also benefit, but we think its commercial aerospace arm (70% of revenue) will hold the stock back compared with defense pure plays.
The Trump win doesn’t change our view that U.S. defense budgets will move higher. However, under a Trump administration, we think growth will come in closer to our bull case, which envisions in the Department of Defense budget--base and overseas contingency operations--going above $650 billion in the government fiscal year 2019 request. Moreover, near-term spending could move upward in the current government fiscal year 2017 due to an increase in overseas contingency operations funding. We note that our forecast entails the removal of the sequestration caps from the budget, which much of Congress and Trump support. The prospect of a continuing resolution running throughout next year has also been reduced, and the resulting uncertainties surrounding defense funding and new program starts have also lessened in our view.
We will get a glimpse of Trump’s spending priorities when his administration issues its first budget request in February of next calendar year, noting that the lead time required to build the Department of Defense’s detailed budget places some limitations on the changes a new administration can realistically make. We plan to conduct an analysis of this request and the potential impact on our fair value estimates for defense contractors.
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Chris Higgins does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.
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