Congress and the White House passed a bipartisan budget deal on Feb. 9, which included large increases in defense spending for fiscal 2018 and 2019. Defense stocks are moving up on the news, but we had already increased our fair value estimates after initial reports regarding the deal began to surface. As a result, we still view the sector--including Boeing (BA), General Dynamics (GD), L3 Technologies (LLL), Lockheed Martin (LMT), Northrop Grumman (NOC), Raytheon (RTN), and TransDigm (TDG)--as fairly to slightly overvalued.
We think defense spending should provide a tailwind to revenue growth over the near to mid-term for the companies we cover, but with profits at all-time highs, we’re not forecasting significant margin expansion. Longer term, we don’t see defense spending going much higher than the top line for fiscal 2019, given pressure from increasing budget deficits. Absent entitlement reform, we think we’ll witness a replay of the 1980s buildup: Despite a strong economy, President Ronald Reagan cut defense spending in the back half of his administration because of high budget deficits.
Chris Higgins, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.