July 8 brought news that the Army plans to cut 40,000 troops over the next two years in a decision that will impact command posts across the globe. By the end of 2017, the Army plans to have 450,000 soldiers, down from levels of 570,000 at the peak of the Iraq/Afghanistan wars and the lowest number of active US Army soldiers since the beginning of World War II. The 450,000 mark is widely believed to be the level at which, if it falls below, the US may not be able to effectively meet defense strategies.
Bare minimum, it would seem.
But while personnel cuts are being implemented, geopolitical uncertainty has only increased. The Islamic State of Iraq and the Levant (ISIL) offensive in Iraq, continuing tensions in the Ukraine, Iran’s and North Korea’s nuclear strike capabilities, cybersecurity intrusions on government systems, and the Ebola virus outbreak are but a few recent events. The threats aren’t going away – and in some ways, it seems they are increasing. Though the UAE, Saudi Arabia, India, China and others are ramping up defense spending, the US is still by far the most important buyer of defense equipment and technologies, accounting for ~40% of the world’s total. Where the US defense budget goes, so goes the fortunes of many defense players.
The US Department of Defense (DoD) fiscal 2016 budget request, released February 2015, offers some background on the trajectory of defense spending in coming years. The fiscal 2016 budget request follows several years of lower defense budgets, but the DoD has requested $585.3 billion in funding for the year, a level that is 4% more than the fiscal 2015 mark, representing an increase of $24.9 billion. Even after sequestration, fiscal 2016 defense spending is still expected to be 85% higher than annual spending in the year of the September 11 attacks. In fact, spending in 2016 is expected to only be 18% lower than the peak spending levels of fiscal 2010, and the DoD continues to expect nominal increases in the base budget, to as much as $570 billion by fiscal 2020, up from ~$534 billion in fiscal 2016.
Image Source: US DoD Fiscal Year 2016 Budget Request
The “sharp increase” in personnel costs—including military pay and allowances, military health care, civilian pay and family support—may crowd out, to a degree, the spending pie allocated to defense contractors, but the expected pace of future defense spending isn’t necessarily unhealthy. For example, spending on next generation intelligence, surveillance, and reconnaissance (ISR) technologies, advanced data analytics, missile defense, nuclear modernization, cyber capabilities, precision strike, and counterterrorism should be strong. Shipbuilding remains a key priority, including the production of destroyers and submarines, and maintaining next-generation Air Force combat equipment (fighters, bombers and munitions) should be expected.
In its second-quarter results, released July 29, General Dynamics pointed to broad-based growth across its various segments, and higher volumes for unmanned programs were the standout at Northrop Grumman during the period. General Dynamics (GD) recently increased guidance for its fiscal 2015 earnings-per-share from continuing operations to the range of $8.70-$8.80, up from $8.05-$8.10 previously, while Northrop Grumman (NOC) raised the bottom end of its fiscal 2015 earnings-per-share target to the range of $9.55-$9.60 per share, up from $9.40-$9.70 previously. Share buybacks will help both meet their respective annual earnings target ranges, and their respective free cash flow and dividend profiles remain as solid as ever.
Our favorite large defense contractor remains Boeing (BA), however, and we point to the company’s commercial aircraft-making operations as the key reason for the fundamental preference. Usually, when defense spending ebbs, commercial production flows, and vice-versa. Boeing’s operations offer a nice cyclical counter-balance, even as we expect commercial strength to continue its uptrend for at least the next few years on the basis of recent backlog levels. We’re keeping a close eye on the group in any case; for income investors, the industry is full of high-yielding ideas that may be worth a look.
Aerospace & Defense – Prime: BA, FLIR, GD, LLL, LMT, NOC, RTN