Takeaway: During "end game", the Pentagon seeks to make strategic, impactful changes in the no-better-than flat budget environment of 2020-24.

With its topline guidance from the White House now set to be ~$30B less than it had been projecting (see my previous note, "How to Find $30B in the Pentagon Budget"), the Pentagon is entering the end game of its annual budget/program review for the Future Year Defense Plan for 2020-2024.  In very closely held sessions, the Pentagon is completing the integration of the program/budget inputs from the 34 military services and defense agencies with SecDef staff analyses and White House policy and budget guidance into a single President's Budget that will go to OMB by Christmas and then to Congress in February. 

In the next two to three weeks, Secretary of Defense Jim Mattis will make final decisions in five major policy areas that will have large impacts on the Pentagon budget for the next several years:

  • TacAir (Tactical Aviation) Mix.  Hottest topic in the Pentagon. For several years now the Air Force and the Marine Corps have been focused on all Fifth Generation fleets, the Air Force with 187 F-22s and 1763 F-35As and the Marine Corps with at least 340 F-35Bs and Cs.  The Navy has already decided on a 50/50 4th Gen/5th Gen mix of F-35Cs and F/A-18E/Fs on its carriers.  There is great pressure on the Air Force and Marine Corps to adopt a similar 4th Gen/ 5th Gen philosophy using F-15x's and F/A-18E/Fs while settling for a smaller force structure.  (Note that DepSecDef Shanahan is a former Boeing VP.)  There are a wide range of impactful options, many of which will be a tough sell in Congress.
    • Expect reductions in planned F-35 procurement (planned to be 84 in FY20 growing to 99 per year) in favor of buying "legacy" jets.
    • Impact on investors: Negative: LMT, UTX, NOC, BAE, etc, etc; Positive: BA, GE, RTN.
    • Navy Force Structure.  Navy has been clear that it wants a 355 ship fleet but its plan to achieve that goal will take 20 to 30 years and 10 to 20% more shipbuilding funds than it currently averages.  The main decision point is the Navy's desire to invest in a block-buy of its Ford-class aircraft carriers to reduce costs below the projected $12B per copy.  Effectively HII would start a new carrier every four years rather than the current five plus year cycle.  DoD leadership is concerned that too much of the Navy's shipbuilding budget is already going to the big ticket Colombia-class ballistic missile submarines and Ford-class aircraft carriers and is pushing back. 
      • Expect a block-buy not to be part of the budget.
      • Impact for investors: loss of opportunity for HII to further improve margins.
      • Troop Presence Outside Europe and the Pacific.  The National Defense Strategy establishes China and Russia as the principal priorities of the Department of Defense and states that gains elsewhere will be "consolidated" while "moving to a more resource-sustainable approach."  That process has begun, e.g., the US has not had a nuclear carrier in the Gulf for months. Last week, the Pentagon announced a 10% reduction of the 7,200 troops operating in Africa.  While exact numbers of US troops in Afghanistan, Iraq and Syria are no longer publicly available, it is approximately 20,000. 
        • Expect reductions in personnel and optempo in the Middle East. 
        • Impact for investors: some reduction in OCO-funded Operations and Maintenance accounts supported by small and mid-cap service providers. 
      • Space  
        • The President has mandated creation of a Space Force as a separate service and apparently all that entails. Estimated to be approximately 20K personnel that will mostly come out of the already personnel-challenged Air Force at a cost of $13B if you believe the Secretary of the Air Force or $5B if you believe the Deputy Secretary of Defense. 
        • The other main subtopic here is a shift away from large bus "exquisite" satellites to smaller commercially operated constellations. 
          • Expect a budget proposal to build a Space Force that is very unlikely to get through Congress. Expect renewed emphasis on use of smaller, commercially provided and operated constellations.  
          • Impact on investors: Space Force impact is not significant.  A change in philosophy on satellites is generally negative for the primes (LMT, NOC, BA) and generally positive for upstarts, e.g. SpaceX. 
      • Missile Defense  
        • First, the Congressionally-mandated Missile Defense Review is overdue. Given the NDS' focus on Russia and China, changes to the current strategy's emphasis on layered defenses focused on North Korea and Iran are possible.  This would be hugely disruptive strategically but not out of line with other Administration decisions on strategic treaties, e.g., INF, climate, etc and its focus on the peer threat.
        • Second, Congress continues to press for, and the newly released National Defense Strategy Commission report endorses, transfer of the responsibility for the procurement of missile defense systems like THAAD (LMT) from the Missile Defense Agency to the respective service (Army).  The Services are resisting because the procurement budgets for these systems are underfunded according to requirements, thus transfer of responsibility would be giving them a future bill for which they have no resources.  
          • Expect more emphasis on space-based systems that are not just focused on North Korea and Iran.
          • Impact on investors: More spending on missile defense in the long run. Positive for LMT, RTN, NOC and BA.