4 Takeaways From the Defense Budget Request
The proposal is mostly in line with our expectations, and our valuations haven't changed.
The Department of Defense has submitted its fiscal 2020 budget proposal to Congress. The $718 billion request represents a 5% increase over fiscal 2019. However, the $247 billion in investment funding (procurement and research, development, test, and evaluation, or RDT&E) is more pertinent for defense companies and is slated to rise only 2% year over year. Despite this lackluster growth, the budget is in line with our expectations, and we’re not moving our fair value estimates for the contractors we cover.
We see four takeaways for investors:
- Congress may increase procurement, so investment growth could come in higher.
- Boeing BA is a winner thanks to the F-15EX, which could be worth $14 billion.
- F-35 cuts are a concern for Lockheed Martin LMT, but Congress may rectify this.
- The DOD is likely to start fiscal 2020 with a continuing resolution, but a budget agreement remains our base case.
In the fiscal 2020 budget, procurement funding dropped 3% versus fiscal 2019, while RDT&E increased roughly 9%. The procurement decline coupled with the RDT&E increase reflects not only the DOD’s gambit that Congress will plus-up procurement but also the full incorporation of the National Defense Strategy, which is focused on RDT&E for nuclear weapons, hypersonics, cyber, autonomy, directed energy, space, and artificial intelligence. Growing development spending may also foreshadow further pressure on margins, as contractors garner more cost-plus contracts and record fewer favorable estimate at completion adjustments. Over the midterm, we believe the DOD may struggle with transitioning development programs to procurement.
The Trump administration is circumventing the Budget Control Act caps by requesting $545 billion in the DOD base budget (cap compliant) and then stuffing $165 billion into overseas contingency operations and $9 billion into emergency requirements. We think this approach is dead on arrival in the House of Representatives. Nonetheless, we believe another budget agreement--probably sometime in early calendar 2020 with the DOD operating under a continuing resolution--represents the most likely outcome, but the process will be painful.
Procurement funding fell on the back of fewer F-35 buys and lower C-130J funding, both of which are Lockheed programs. Army ground vehicles are seeing lower procurement funding, but most of this spending decrease won’t affect General Dynamics GD, since the cuts are focused on the JLTV (Oshkosh) and AMPV ( BAE Systems BAESY). More broadly, we think the Army’s reprogramming of its budget to favor modernization over legacy programs means companies and business units with significant Army exposure, like L3 Harris Technologies LLL, General Dynamics, BAE Systems, Boeing’s helicopter business, and Lockheed’s Sikorsky business, face a more volatile budget environment going forward.
The Navy added another Virginia-class submarine (General Dynamics and Huntington Ingalls Industries), raising the quantity to three for fiscal 2020. We’d note that the Navy’s planning includes savings from an aircraft carrier retirement (the USS Harry S Truman CVN-75), something that may not get through Congress.
The Air Force is slated to account for about half of the increase in RDT&E spending for fiscal 2020, with the B-21 bomber ( Northrop Grumman NOC) driving Air Force RDT&E higher. Northrop alluded to B-21 revenue leveling off in 2019 during its full-year earnings call, so the fiscal 2020 budget increase is good news for calendar 2020. Turning to fighter aircraft, the fiscal 2020 budget request includes 78 F-35 buys, which represents 15 fewer aircraft on a year-over-year basis. Both the Navy and Air Force plan to trim their procurement quantities relative to last fiscal year. However, we think it’s a distinct possibility that Congress will move to plus-up F-35 procurement. On the Boeing F-15EX, the DOD is budgeting a bit more than $1 billion to purchase eight aircraft in fiscal 2020. This $1 billion includes industrial startup costs, so we’d caution investors against extrapolating any unit costs from this figure. Per DOD comments, Boeing may eventually deliver 144 F-15EX fighters to the Air Force.
Finally, we highlight that the DOD is planning for $7.7 billion in efficiencies for fiscal 2020. Although we haven’t gotten a look at the Future Years Defense Program yet, we suspect there might be an efficiency wedge included in the long-term plan that includes savings the DOD expects to materialize. This would represent a risk, in our view, since achieving these efficiencies across the DOD bureaucracy can often prove challenging.