Takeaway: Please note we are removing LMT (long) from Investing Ideas today.

"I'm somewhat less bullish on defense spending, for now (from this time and price)," Hedgeye CEO Keith McCullough writes today. As a result, we're removing Lockheed Martin (LMT) from the long side of Investing Ideas.

Why?

Below is an institutional research note written by Hedgeye Senior Defense Policy analyst Lt. General Emo Garner USMC Ret. explaining why the Pentagon's request for $30 billion in additional fiscal year 2017 spending authority "has tough sledding ahead."

We Are Removing Lockheed Martin From Investing Ideas - emo note

On Thursday the Pentagon released details of its long-expected supplemental request for $30B in additional FY17 spending authority.  The request includes a $13.5B (+13%) increase in planned procurement spending, $13B in increased operations and maintenance, $2B in increased R&D and $1B in MilPers.

At the same time, OMB outlined $18B in cuts to non-defense spending in FY17 and its outline for FY18 spending by the entire Federal government. Details of how the Pentagon intends to use its FY18 budget authority are not expected until early June.

The Pentagon's request for an additional $30B in baseline spending will increase total Pentagon budget authority for the current fiscal year to $619B and is consistent with what we have been telling clients for several weeks.  However, $25B of the increase is to base spending which will violate the Budget Control Act (BCA).  (see chart below)

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Increases to the Pentagon's FY17 BCA cap require Democratic support in the Senate which will only come with equivalent increases to the non-defense cap.  OMB has gone the other way and proposed $18B in cuts to FY17 non-defense spending as well as shifting another $3B from non-defense agencies to DHS for the "wall".  The OMB outline for FY18 spending promises more of the same by shifting $54B in non-defense spending to defense and maintaining the discretionary spending ceiling. 

Simply rejecting the supplemental request is not a good alternative.   The National Defense Authorization Act, which has already been signed into law, has created bills for the Pentagon which must be paid, e.g., increased military endstrength. Deteriorating aircraft and ship readiness has been well documented. 

The Continuing Resolution expires on April 28.  Given the scheduling pressures and acrimony within Congress, i.e.,  "repeal and replace", Supreme Court justice and other confirmations, Easter recess (!), there is not much legislative calendar time let alone will to get an amended Budget Control Act passed before the deadline. 

The easy path for Congress would be to merely extend a "clean" CR beyond April 28.  While this would avoid government shutdown, it would be damaging to the Pentagon. Under a CR, there is a mismatch of appropriated funds.  Given the inability to execute new program starts or increase production over FY16 levels, there is more procurement money than can be obligated.  Satisfaction of warfighter needs is delayed.  On the other hand, there are insufficient Operations and Maintenance funds.

Since priority goes to forward deployed and next-to-deploy units, home station units and ships have to carry all shortfalls.  Maintenance windows are missed, training is curtailed. This hurts the preparation of units in the queue and results in a rapidly accelerating downward spiral of deteriorating readiness that takes years to recover from.  Many of the readiness problems with tactical aircraft and ships widely reported today are a result of the extended CR and subsequent sequestration that took place in FY13, four years ago. 

An alternative for Congress is to identify some or all of the baseline portion of the supplemental request as OCO spending which is exempt from the BCA caps.   The House tried this late last year and it was rejected by the Senate, hence the CR we have today. OMB Director Mulvaney has railed against the practice and the shape of the supplemental request reflects his aversion. Nevertheless, we believe that this is the most likely course of action.  Simply adding $30B in OCO is no slam dunk so the size of the request is likely to be reduced by $10B or more.