These are good times for defense primes but clouds are building on the post-election horizon.
- Q2 reports were strong:
- Revenues were up from 4% (GD) to 19% (NOC) with most companies (LMT, BA Defense, RTN, HII) at ~ 8% y/y
- EPS for LMT were up 23%, NOC 12%, RTN and GD 5-6% y/y. HII an exception here -43% because of pension and cyclical anomalies.
- Significantly, book to bill rates for the quarter were 1.3 to 1.6 reflecting the government finally getting Trump budget increases on contract. Backlogs are large and still growing: LMT's is sitting on $137B, NOC $67B and BA defense $64B.
- The SPADE (^DXS) index of weighted defense stocks is up 31% YTD compared to 17% for the S&P 500 through Friday 2 August.
- The near term Pentagon budget situation has clarified:
- Congress and the White House set Pentagon spending levels at $705B for FY 2020 and $708B for FY 2021 compared to $686B in FY 2019 and $606B just two years ago (FY 2017). While the FY 2020 level is ~$12B less than what the President formally requested in February, it is actually $5B more than the Pentagon said it wanted as recently as December. The President's publicly stated gambit of asking for more than you really want worked!
- The specter of sequestration has been removed as the Budget Control Act of 2011 (BCA) finally expires at the end of FY 2021, the last year of this latest two year deal. Although the draconian cuts have only been applied once (2013), the effects from that one application have adversely impacted readiness to this day. While the threat of mechanical $50-130B annual cuts has been removed two years at a time every two years since 2013, its existence has always been a risk that has clouded both government and industry investment plans.
- Pentagon budget outlays lag headline budget authority discussions (like the one above) by one to three years but are the best indicator of defense industry revenues. Pentagon investment (R&D + Procurement) outlays for the first nine months of FY 2019 are $19B higher (+14%) and growing compared to the same period in FY 2018. The large budget authority increases from the first part of the Trump administration are now hitting the street and driving defense industry revenues. By 2021, investment outlays will be as high as they have ever been in constant dollars. Given the most recent budget deal, outlays will remain at levels exceeding the Reagan buildup through 2023. How long will this go on?
- The 2020 election will be a turning point for the Defense Budget but not in the most obvious ways
- While the expiration of the BCA eliminates "caps" or ceilings, it also eliminates floors. The BCA established a clear balance between defense and non-defense spending. Whoever presents the FY 2022 budget in February 2021 will have to present a complete budget without gimmicks (e.g., hiding baseline defense expenses in Overseas Contingency Operations funds) and that makes clear trades between defense and non-defense budget levels.
- Bills are coming due and the defense budget will pay its share in FY 2022 and begin to see stark changes, regardless of who wins the election.
- OMB projects a $1T federal deficit this year, $1.05T next year and $1.02T in FY 2022. Infrastructure demands are becoming critical.
- While it is a given that any of the Democratic candidates, if elected, will put a damper on future defense spending, even President Trump has signaled large budgetary changes in FY 2022. Pentagon budget officials who are now beginning the planning process that will result in the Pentagon's FY 2022 budget proposal that will be presented to the next President in December 2020 are running five percent cut drills on existing guidance (= ~$36B of ~$727B forecast).
- The Commandant of the Marine Corps recently signaled that he is willing to reduce the size of the Corps in order to keep modernization on track - a sure sign that pressures are building despite a large topline.
- Fill or kill. A record 42% ($104B in FY20) of the Pentagon's current record investment budget is going to R&D. That R&D has to convert to actual production of capability at some point. From 2021 on, all of the huge R&D programs now underway, e.g., B-21 bomber, GBSD (ICBM replacement), the Army's six modernization priorities (Long Range Precision Fires, Next Gen Combat Vehicle, Future Vertical Lift, etc) will begin to face major milestone decisions on further development and production. Nascent programs will have to compete for a place at the trough with programs already there: F-35, KC-46 tanker, submarines, etc. Winners and losers. Change is coming.
