While presenting the fiscal 2018 (FY 2018) ‘America First Budget’ in March, President Trump granted an open-handed allotment to defense spending. Through this proposal, Trump not only repealed defense sequestration enacted by President Obama in 2011, but also made American history by presenting the largest one-year increase in the Department of Defense’s (DoD) funding.
In fact, this initiative to ‘rebuild’ the U.S. Army has been the primary force that drove stocks in the aerospace and defense industry to new peaks in the past few months.
Also, other factors like frequent conflicts arising across the Middle East, the ongoing cross-border missile tension between the U.S. and North Korea, and recent cyber-security threats that affected nations worldwide continued to boost the Aerospace sector as a whole.
Altogether, these factors have helped the nation to remain atop others when it comes to military expenditure. Notably, military spending consumes more than 50% of the U.S. discretionary budget, way ahead of the second and third spot holders China and Russia, respectively.
Many of the defense majors in the nation are doing a decent job, propelled by the following strategies:
Recent Upside in Budget: On Jul 14, 2017, the U.S. House passed the FY18 defense policy bill worth $696.5 billion that extensively surpassed President Trump’s budget request. The bill provisioned $621.5 billion for the Pentagon's base budget and Energy Department nuclear programs and $75 billion for the Overseas Contingency Operations (OCO) account. In addition, the bill will include $6 billion to boost Navy shipbuilding. This would benefit the nation’s prime shipbuilders like Huntington Ingalls Industries, Inc (HII - Free Report) and General Dynamics Corp. (GD - Free Report) .
The FY18 defense budget reflects a 10% hike from the FY16 level. Along with this came a request for additional FY17 appropriations, which requested an extra base budget of $24.9 billion and OCO budget worth $5.1 billion. This took the FY17 total defense budget proposal to $610 billion. This appropriation also called for a hike of more than 26,000 active military forces from the original FY17 request.
In addition, it included future investment capabilities worth $15.5 billion in the aerospace and defense industry to improve the nation’s near-term and mid-term combat promptness.
Moreover, it sought to invest $13.5 billion in procuring additional and modernizing Army Apache and Blackhawk helicopters, F-35 and F/A-18 fighter aircraft, tactical missiles, unmanned aircraft systems and Terminal High Altitude Area Defense interceptors. No doubt this spending will boost defense stocks, in particular The Boeing Company (BA - Free Report) and Lockheed Martin Corp. (LMT - Free Report) that manufacture such equipment.
The prior administration’s FY17 budget revealed plans to expand the size of the force over the next several years to a level of 980,000 soldiers, 308 ships, 182,000 active-duty Marines and 55 Air Force tactical fighter squadrons. With President Trump being highly in favor of defense spending, these numbers have a huge chance of being further elevated going forward.
Foreign Military Sales (FMS): In addition to catering to a large domestic market, U.S. defense majors are expanding their foreign markets rapidly, taking advantage of regional tensions prevailing in the Middle East. Such tensions include civil wars in Syria and Bahrain, the unrest in Iraq, Yemen and Libya, and Iran’s strained relationship with the U.S. Moreover, the recent vehicle and knife attacks made in London show that the developed nations of Europe have also failed to escape the scythe of terror.
Further, lack of regional arms control regulation has prompted Asian emerging nations like India and Japan to boost their arsenals. The U.S., being the top global arms exporter, is seeing added arms imports by these foreign countries. This is giving U.S. aerospace and defense a big boost.
Of the recent FMS contracts, notable is the arms deal worth $110 billion that Trump signed with Saudi Arabia in May. This agreement with a potential value of $350 billion over 10 years outweighed the $38 billion U.S.-Israel defense pact that was inked in Sep 2016. According to major media sources, Lockheed seemed to have garnered the majority of this huge arms deal, with Saudi Arabia set to procure its varied defense products for $28 billion.
Also, Boeing clinched a significant portion of the arms package and will sell its Chinook helicopters and associated support services to the Saudis. Further, Raytheon Company (RTN - Free Report) signed a memorandum of understanding (MOU) with the Saudi Arabia Military Industries Company, to cooperate on defense-related projects and technology development.
Last month, Lockheed Martin inked a landmark deal with Tata Advanced Systems Ltd. to jointly manufacture the F-16 Block 70 fighter jets of the former in India. This came as a move to expand its foothold in the market of India, the world’s largest military weapons importer.
Earlier, doubts were raised in relation to Trump’s foreign defense policies during the early days of his presidency. However, over past few months, the U.S. situation in terms of FMS deals seems to have only improved.
Restructuring: To maintain margins in a tough business environment, companies are squeezing costs out of their operations and diversifying into new business areas. One such diversification play has lately been exhibited by Boeing, which resorted to an unconventional business line expansion in “Space.”
In particular, Boeing in collaboration with NASA’s Space Launch System (SLS) will deliver “Deep Space Gateway” and “Deep Space Transport.” While, the Deep Space Gateway is a space outpost, the Deep Space Transport is a vehicle that will take humans to longer-duration space missions. Management expects to construct the gateway in four launches by the early 2020s.
Interestingly, Trump has allocated government contribution worth $3.7 billion for fiscal 2018’s SLS and associated ground system. Once the deep space gateway and transport vehicle concepts are materialized, Boeing, being the prime SLS contractor, will gain the most.
Increased Focus in Cyber Spending: In May 2017, a massive cyber-attack, comprising more than 45,000 attacks, hit almost 100 countries including the U.K., Russia, Ukraine, India, China, Italy, the U.S., and many more. Indeed, computer attacks are among the most pressing security challenges affecting global economy. The U.S. being the most digitally advanced country makes it the worst affected.
This is pushing its focus toward electronic warfare, C4ISR (Command, Control, Communication, Computers, Intelligence, Surveillance and Reconnaissance) and cyber security. In this context, the FY 2017 appropriation budget request includes funding worth $7.2 billion for operations and maintenance to address urgent readiness shortfalls across the joint force, including improvements in cyber intelligence capabilities.
Moreover, Trump’s proposed FY 2018 budget allocates $1.5 billion for Homeland Security to tackle cyber attacks, including protecting critical infrastructure.
The Trump Factor: It goes without saying that President Trump has been immensely influencing the U.S. aerospace and defense industry from the very first day of his tenure. Although initially analysts were skeptical of this industry’s future under Trump’s realm, the ultimate result has been encouraging so far. A few instances will make this point clear.
In Dec 2016, Trump slammed Lockheed Martin’s F-35 program – the world’s largest defense project – with an ‘out of cost’ tag. In Mar 2017, Lockheed’s CEO Hewson admitted that Trump’s insistence in cutting cost of F-35 did have a major influence on this program’s cost-saving initiative. Management now plans to reduce $85 million or less per plane by 2019.
In March, Trump also urged his fellow North Atlantic Treaty Organization (NATO) member nations to contribute more to the organization’s defense fund. Although Trump’s comments were widely criticized, since the U.S. is the largest contributor to NATO (about 72%), it is expected that such persuasion will increase defense funds from the allied nations as a whole. Clearly, U.S. defense majors with greater foreign exposure will be the direct beneficiaries of the situation.
In the same month, the Trump administration announced plans to pursue the $5 billion sale of 19 Lockheed Martin F-16 jets to Bahrain that got stalled owing to human rights’ concerns last year. As told to Congress, the U.S. State Department will reinstate the deal, putting aside human rights’ conditions imposed by the Obama government. Given that Bahrain is one of the nation’s valued customers, the deal, if finally approved, will surely give a big boost to Lockheed Martin’s business prospects.
Stocks to Consider
Considering the aforementioned drivers of the defense stocks and the fact that budget sequestration will mostly fail to survive under Trump’s administration, we are bullish on AeroVironment, Inc. (AVAV - Free Report) , sporting a Zacks Rank #1 (Strong Buy).You can see the complete list of today’s Zacks #1 Rank stocks here.
We are also positive on stocks like The Boeing Company (BA - Free Report) , Huntington Ingalls Industries, Inc. (HII - Free Report) and Northrop Grumman Corp. (NOC - Free Report) ; all of them carrying a Zacks Rank #2 (Buy).
Increasing tension and violence across the globe have spurred nations to make heavy investments in their aerospace and defense industry. The U.S., home to the world’s major weapons manufacturers, is potentially a big beneficiary of this. So investing in the nation’s defense stocks seems to be a good idea now, when its macroeconomic attributes as well as budgetary amendments are in favor of the industry.
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