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Is U.S.-North Korea Tiff Driving the U.S. Defense Industry?

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While President Donald Trump and North Korean president Kim Jong-Un indulged in verbal blows over the past few months,the U.S. aerospace and defense industry has thrived. There’s no denying that, while deal making activities have been historically boosting defense stocks, repeated counteractive missile-tests conducted by these two nations have been vital to the broader Aerospace sector’s Q3 outperformance.

On top of the possibility of military action in the Korean peninsula, a recent wave of mergers between big aerospace and defense companies has given this industry a lift.

In addition, Trump’s fiscal 2018 (FY 2018) ‘America First Budget’ has been another determinant of the defense stocks’ solid gains. Impressively, through this proposal, the President not only repealed defense sequestration enacted by his predecessor in 2011, but also made a mark in American history by presenting the largest one-year increase in the nation’s fund for the Department of Defense (DoD).

Also, other factors like Trump’s new defense strategy for Afghanistan, recent cyber security threats that affected nations worldwide as well as sporadic attacks in European nations continued to boost the Aerospace sector as a whole.

Altogether, these factors have helped the United States to remain at the top 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:

Frequent U.S.-North Korea Tiff: The now familiar geopolitical tension between North Korea and the United States is one of the major reasons why shares of the U.S. defense contractors have surged multiple times in the recent past. Moreover, in response to Kim’s fanatic military actions taken against the United States and threats to its ally Japan, Trump made the "fire and fury" comment. He strongly condemned Kim’s hostile action, reflecting the U.S.’ readiness to counter-attack any time necessary and in turn, defense stocks rallied. In particular, companies that either manufacture high-end missiles or offer missile surveillance services like Northrop Grumman Corp. (NOC - Free Report) and Raytheon Company (RTN - Free Report) gained the most.

While such cross-border tensions hinting at the possibility of upcoming wars does not favor a nation’s GDP growth, these act as forerunners for stock market surges, especially for stocks in the aerospace and defense industry. 

Recent Upside in Budget: On Sep 18, 2017, the U.S. Senate passed the National Defense Authorization Act (NDAA), better known as the FY18 defense policy bill, worth roughly $700 billion that extensively surpassed President Trump’s budget request. The bill provisioned $640 billion for the Pentagon's base budget and $60 billion for the Overseas Contingency Operations (OCO) account. It authorized an additional $8.5 billion for the Missile Defense Agency to strengthen homeland, regional and space missile defense, which is $630 million higher than the Trump administration's request.

In addition, the bill includes $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 legislation also authorizes over $141 billion for military personnel costs, providing a 2.1% increase in pay for troops.

Moreover, the FY18 defense budget that Trump presented this March reflects a 10% hike from the FY16 level. With Trump being highly in favor of defense spending, these numbers have a huge chance of getting elevated in the coming days.

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. over oil. Moreover, the recent vehicle attacks in London, Barcelona and Paris 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. 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 business a big boost.

Of the recent FMS contracts, notable is the $3.8 billion-worth deal that Lockheed Martin Corp. (LMT - Free Report) sealed with the Bahrain administration, in October. Per the deal, an arms package including Lockheed Martin’s F-16 jets, upgrades, missiles and patrol boats; will be sold to the Bahrain Defense Force. Notably this deal got stalled last year, when Obama’s administration disapproved it, citing Bahrain government’s failure to demonstrate noticeable progress on human right issues.

In July, Lockheed Martin inked a landmark deal with Tata Advanced Systems Limited (TASL) 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. Surely, these FMS deals will boost the company’s F-16 product line considerably, which has been suffering lately due to dearth of orders.

Notably, doubts were raised in relation to Trump’s foreign defense policies during early days of his presidency. However, the U.S. situation in terms of FMS deals seems to have only improved, under his rule.

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.” It is imperative to mention in this context that Boeing’s management has identified satellite business and space exploration as the two "key" opportunities to generate more growth.

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 the past few months, frequent cyber-attacks, following the one in May 2017, which comprised more than 45,000 attacks, have been hitting varied nations on the global map including the U.K., Russia, Ukraine, India, China, Italy, the U.S., and many more. The latest hacking of Equifax’s database that compromised sensitive information of 143 million U.S. consumers, is a bright instance that computer attacks have emerged as the most pressing security challenges affecting global economy.

This, in turn, has pushed the United States -- the largest digitally advanced country -- towards enhancing its electronic warfare, C4ISR (Command, Control, Communication, Computers, Intelligence, Surveillance and Reconnaissance) and cyber security. In this context, Trump’s proposed FY 2018 budget allocates $1.5 billion for Homeland Security to tackle cyber attacks, including protecting critical infrastructure.

Mergers & Acquisitions: New macro challenges along with rising completion are prompting aerospace and defense industry players to revisit their business models as well as expand their core operations and product lines. One such example is the acquisition deal that United Technologies Corp. (UTX - Free Report) made this September, to take over Rockwell Collins, Inc. (COL - Free Report) for $30 billion.

This mega-deal is expected to create one of the world’s largest aircraft-equipment manufacturers. With the acquisition, Rockwell Collins’ commercial and military aircraft avionics business will merge with United Technologies’ wide portfolio that includes aircraft engines, structures, cockpit and cabin controls, ventilation systems and other electronic and mechanical devices used in aviation.

In the same month, Northrop Grumman agreed to buy rocket-maker Orbital ATK, Inc. OA, for $9.2 billion. Post deal, Northrop Grumman will benefit from Orbital’s rocket motors, missiles and electro-optical countermeasure product lines. Also, the latter’s knowledge and expertise in satellites, spacecraft components and commercial space launch system will further expand Northrop Grumman’s product offering.

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. A few instances will make this point clear.

In March, Trump 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, with the United States being 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.

Let’s also not forget that Trump revealed a reversal of strategy in Afghanistan, this August, promising to “fight to win” instead of withdrawing entirely. He vowed to ramp up U.S. engagement in Afghanistan, the country’s longest war to date. Trump also criticized Pakistan for being a safe haven for terrorists. In tandem with these announcements, anticipating more inflow of contracts, defense stocks moved north, keeping up its recent upward trajectory.

Stocks to Consider

Considering the aforementioned drivers of the defense stocks, we remain positive on stocks like Huntington Ingalls Industries, Inc. (HII - Free Report) and Leidos Holdings, Inc. (LDOS - Free Report) and Wesco Aircraft Holdings, Inc. (WAIR - Free Report) , all of which carrying a Zacks Rank #2 (Buy). You can seethe complete list of today’s Zacks #1 Rank stocks here.

We may also consider better-ranked stocks like The Boeing Company (BA - Free Report) and Northrop Grumman Corp (NOC - Free Report) , which carry a Zacks Rank #3 (Hold).

Bottom Line

Increasing geo-political tensions across the globe have spurred nations to ramp up their arsenal and with the United States being home to the world’s major weapons manufacturers, demand for its defense equipment is growing by leaps and bounds. Considering the favorable macroeconomic attributes as well as budgetary upgrades, it seems wise now to invest in U.S. defense stocks.  

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