Following dramatic spending increases in both 2018 and 2019, Pentagon planners say they are not likely to request another big leap for 2020. A slowing defense budget is typically a big worry for defense contractors. But this time around, there are reasons to believe the industry will be fine.
Spending plans for 2020 are not yet finalized, but Robert Hood, the assistant secretary of defense for legislative affairs, in an interview with The Military Times published Aug. 4, said the Defense Department is not expecting to see its budget top line grow. He said that the Pentagon would instead have to find savings to fund additional programs, which could mean either additional pressure on existing contracts or a slowdown in new contract awards.
"If you look at '18 and '19 -- two nice step-ups, in terms of funding," Hood said in the interview. "And the intent is there's not going to be another big step-up again."
Contractors including Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC), General Dynamics (NYSE:GD), and Raytheon (NYSE:RTN) have been richly rewarded over the last two years. The current-year Pentagon budget, at $700 billion, is the largest in history and represented a 15.5%, or $94 billion, jump from the year prior. That's the largest single-year jump since a 26.6% gain in 2002.
The 2018 budget was part of a two-year agreement reached in Congress, with 2019 funding expected to rise to $717 billion.
Flat is better than down
Part of the reason for the big jump this year was a congressional deal reached in February to circumvent the Budget Control Act of 2011, which put firm limits on both military and domestic spending. Defense advocates had complained that the caps were squeezing Pentagon resources and risked reducing the military's readiness. They also depressed valuations among the largest contractors.
This year's compromise provides only a two-year reprieve from sequestration, and while congressional leaders are insistent that they will not allow the caps to return in 2020, a spending slowdown remains a concern for defense companies, especially if the United States were to return to a divided government following this year's midterm elections. Hood made it clear the Pentagon is well aware of the political sensitivity of further spending increases as it formulates its 2020 request.
"We understand that Congress really took some political risk in some cases to take care of the department," Hood said. "We are going to do everything we can to live up to our side of the obligation to spend it wisely."
If the Pentagon, by maneuvering carefully and not asking for too much, helps ease the political path for lawmakers to do away with sequestration for good, that benefit will far outweigh any potential near-term downside of a flat budget for contractors.
Money will be found
Hood said a key to his plans is finding savings in the existing budget. The data would suggest there are opportunities to do more with the money that has been allocated.
Operations and maintenance funding has grown to 38% of the total budget from 27% in 1986, according to an analysis published in May by the American Enterprise Institute (AEI), despite the Pentagon maintaining a much smaller military. In 1986, the U.S. had 583 active battle force ships, 10,559 Air Force aircraft, and 1.49 million Army personnel. By comparison in 2019, there are only 299 ships, 5,426 aircraft, and 1.03 million Army personnel.
Procurement has been "the clear loser" from this trend, according to the AEI, falling from about one-third of 1986 appropriations to one-fifth of the 2019 budget. Admittedly cutting out the waste in those numbers is no easy task, but if Hood is committed to finding ways to trim costs, there should be plenty of opportunities to stretch the budget dollars.
The Pentagon also has a separate, off-budget allocation vehicle at its disposal. While overseas contingency operations (OCO) funds are designed for spending related to ongoing operations, some procurement happens within the account. It can also be used to cover some of the ongoing maintenance costs, potentially opening additional budgeted funds for procurement and R&D.
Finally, it's worth noting that many of the allocations made for weapons purchases as part of the current-year and 2019 budgets will be spread out over a number of years, providing some cushion to contractors even if funding is eventually cut.
Don't panic, but watch carefully
In 2011, when sequestration was enacted, shares of defense primes dropped by as much as 15%. Given how far those stocks have climbed of late, with the outperformers up more than 50% over the last three years, a return to spending caps could cause an even bigger reaction this time around.
There's likely to be some investor disappointment if 2020 really does come in flat, especially since as recently as last December, Pentagon officials were declaring it would be the "masterpiece" of the White House's plan to rebuild the military. But anything short of a return to sequestration is a win for the sector.
Investors do need to remain alert. Defense primes are currently trading at multiples to sales and earnings unseen for more than a decade. The bull case to justify those valuations is that higher spending levels will allow the companies to grow into those multiples. That becomes harder if growth is restrained.
We knew going in that the Pentagon spending surge would not last forever. If it ends with a gradual tapering and not a sudden crash, there's no reason to worry about the defense industry.