Stock Strategist Industry Reports

What Will Democrats' Control of House Mean for Defense Stocks?

Chris Higgins, CFA

The Nov. 6 midterm election results saw the Democrats taking over the U.S. House of Representatives, while the Republicans retained the Senate. House Armed Services Committee ranking member Rep. Adam Smith will now assume the chairmanship, while Rep. Pete Visclosky will take over as defense appropriations subcommittee chairman. We anticipate both will try to ramp up scrutiny of Department of Defense nuclear modernization, specifically the B-21 bomber (Northrop Grumman) and the Columbia submarine (General Dynamics). We also think the duo will increase oversight of overseas contingency operations spending. That said, Smith’s district is in the Puget Sound region, and we believe he will be an advocate for  Boeing’s (BA) programs relative to other priorities.

Our bull case envisions bipartisanship and an avoidance of gridlock, which creates funding certainty for defense names, but our bear case anticipates budget chaos and sequestration for fiscal 2020. Our base case entails a muddle-through in which a 2020 continuing resolution, which freezes funding at the previous year’s levels, occurs but an agreement to avoid budget caps is eventually struck. Flying under investors’ radar is the likely resignation of Defense Secretary James Mattis. Depending on who replaces Mattis and when, we think the Pentagon might be at a disadvantage as it battles for its piece of the fiscal 2020 appropriations.

Although we continue to forecast accelerating growth for the U.S. defense majors through the first half of 2019 as outlays ramp thanks to previous budget increases, our projection for modest growth in the fiscal 2020 defense budget is now on shakier ground. However, any decrease or flattening of defense budget authority won’t be felt until later in calendar 2020. We are maintaining our fair value estimates for the defense companies we cover; wide-moat names  General Dynamics (GD),  Northrop Grumman (NOC),  Raytheon (RTN), and  Lockheed Martin (LMT) are all trading at slight discounts to our valuations.

When he was the ranking member on the Armed Services Committee, Smith voted for recent defense spending increases proposed by the Trump administration, but he’s vocal about ramping up oversight of the military’s overseas operations. We think this view combined with his opposition to some large programs could translate into more scrutiny directed toward the Department of Defense budget and in particular overseas contingency operations funding, which in turn could strain the procurement and research, development, test, and evaluation accounts--investment accounts that most directly affect defense hardware firms--within the base budget. In addition, modernization of the nuclear triad could be reviewed by Smith, who has said, “I think nuclear weapons are an area where we are spending too much.”

Visclosky has been less outspoken than Smith, but based on his votes and policy stances, we believe his positions are similar: more transparency and oversight with Department of Defense spending coupled with a rethinking of the nuclear modernization program. The B-21 bomber, Ground-Based Strategic Deterrent (Northrop and Boeing competing), and the Columbia-class submarine could face funding cuts.

Smith has also been an outspoken critic of Saudi Arabia’s operations in Yemen, and this could affect U.S. companies’ existing and pending contracts with the kingdom. On the other hand, Smith’s ascension to the majority is probably a positive for Boeing; he represents the Puget Sound area of Washington, and although Boeing primarily focuses on commercial aircraft in the region, it does conduct work on the KC-46 tanker and P-8 there. And he worked effectively with the Republicans on the committee while he was in the minority, indicating that he’s probably a bit more pragmatic vis-a-vis defense funding than some of his campaign rhetoric suggests. For his part, we think Visclosky may put greater emphasis on readiness, training, and military pay plus benefits at the expense of weapons development and procurement.

Although less visible, changes at the Department of Defense are even more likely to occur now with Mattis possibly leaving his post soon. We’ve already seen several high-level civilians walk out the doors at the Pentagon, and more could be in the offing. The departure may come at an inopportune time because the Department of Defense may need to protect its desired top line of $733 billion for total fiscal 2020 defense spending; the president has informally floated a lower $700 billion figure.

Regardless, our thesis that previous increases in defense budget authority will translate into accelerating defense contractor revenue growth through the middle part of calendar 2019 remains intact. Moreover, any pressure on the fiscal 2020 budget authority for the Department of Defense won’t translate into significantly lower revenue growth for defense hardware providers until later in calendar 2020, given the natural delay between budgeted dollars and outlays.

Chris Higgins, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.

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