The U.S. military has a money problem: It doesn't have enough money to buy all the things it wants. But is President Donald Trump planning to fix that?
You might be surprised to hear that the Pentagon is starved for cash given that the United States already purportedly spends "more money on defense than the next 13 countries combined." But the U.S. also needs to buy more things than other nations do, for example, a large navy to secure global sea lanes.
Trump has famously said he wants to increase the size of the U.S. Navy to 350 warships, up 22% from its present level of 287 ships in the battle force. But there are two obstacles to reaching that goal: First, growing the Navy requires not just building additional new warships to expand the fleet, but also building replacement vessels just to maintain its current strength as older warships age out. And second, whether we're talking about replacement warships or additional warships -- some warships cost more than others.
President Trump's new defense budget could be a big "hit" with investors. Image source: Getty Images.
We're gonna need a bigger (fleet of) boat(s)
Take the Columbia-class nuclear powered (and nuclear armed) ballistic missile submarine, for example.
The Navy considers this program nonnegotiable, inasmuch as nuclear-armed submarines are considered an essential leg of the nuclear deterrence "triad" (consisting of land-, air-, and sea-based nuclear missiles). But this is one very expensive stool-leg: Between initial development costs ($12.9 billion, according to the U.S. Government Accountability Office) and the cost of procuring a total of 12 Columbia-class SSBNs ($89.2 billion more), it's estimated the entire Columbia program will cost more than $102 billion -- and that's just to partially replace the 14 Ohio-class SSBNs currently active in the fleet.
Not to belabor the point, but that's an awful lot of money to spend when the end result will be two fewer ships in the fleet than when the effort began. What's worse, the GAO isn't even certain that the Navy will be able to accomplish its goal at the targeted price, and believes building 12 Columbia-class submarines will probably cost more than $128 billion.
And it gets worse.
Military math
Last month, Popular Mechanics crunched the numbers and determined that growing the Navy to 355 ships (as some have argued for) would cost "approximately $126 billion ... over several decades." This comes on top of the $102 billion or $128 billion needed to build the replacement SSBNs. Now, historically the U.S. Navy has spent only about $13.6 billion per year on building new warships (both replacements, such as the Columbia-class, and fleet expansion warships), according to the Congressional Budget Office. Just building the first Columbia-class SSBN (estimated at $13 billion in cost) would consume nearly one full year's worth of that budget, however. Subsequent units (GAO estimates a unit cost of $8.5 billion) will each cost about 62% of a year's shipbuilding funds at historic levels.
If the Navy is forced to devote such a large portion of its shipbuilding budget to replacing existing warships, this will make it very hard indeed to grow the rest of the fleet to 350 ships. In order for the Navy to reach its fleet-size goal, therefore, either the Columbia program must be scaled back to free up funds for building new warships, or else the funds devoted to building ships must vastly increase. In fact, the Congressional Budget Office estimates an annual shipbuilding budget of $28.9 billion (i.e., more than twice the historic average) will be needed if the Navy is to both replace the SSBN fleet and grow the fleet at large.
President Trump-approved
That's why it may be good news for the Navy -- and for investors in naval military contractors -- that Trump is now advocating for a much bigger military budget.
The Pentagon's fiscal year 2019 defense budget already calls for funding shipbuilding at an elevated level of $20.8 billion. The administration was hoping to cut that next year in accordance with a planned reduction in overall defense spending from $716 billion to just $700 billion in FY 2020. This week, however, Politico is reporting that the administration has decided to reverse course and instead call for an increase in defense spending to $750 billion -- a near-5% increase to the defense budget.
Supposedly, the larger number is a negotiating tactic aimed at getting Congress to eventually compromise on an increase to $733 billion, but even that smaller number would represent a 2.4% increase in defense spending -- and, incidentally, enough money to more than cover the gap between historical Navy shipbuilding spending and the $28.9 billion needed to both build the Navy's replacement SSBNs and begin growing the fleet toward 350 ships.
Who benefits?
Granted, it's anything but a sure thing that all this new money would go to the Navy -- if Congress even authorizes a funding increase at all. There does, however, appear to be a growing consensus that the Navy needs at least more money than it's been getting so far, and that could be good news for key military shipbuilders General Dynamics (GD 1.17%) and Huntington Ingalls (HII 1.05%).
Last year General Dynamics derived $8 billion of its $31 billion in annual sales from the "marine" sector -- mostly naval warships -- according to data from S&P Global Market Intelligence. (General Dynamics also builds transports for civilian oil companies.) As one of the country's two builders of nuclear-powered submarines, General Dynamics would benefit if funds are found to purchase the Navy's new SSBNs, and more generally from purchases of new warships period.
The bull case for Huntington Ingalls is even more compelling. With only $7.4 billion in annual sales, Huntington Ingalls derives almost the entirety of its revenue from military shipbuilding (surface combatants and, even more important, nuclear-powered submarines and aircraft carriers). As a result, any increase in naval spending would be a windfall. Huntington would benefit from more Pentagon orders for submarines, but probably benefit disproportionately (relative to General D) if the Navy is able to secure funding for its expansion to a 350-ship Navy.
At recent valuations of just 16.6 times earnings for General Dynamics and an even cheaper 12.5 times earnings for Huntington Ingalls, I think both of these stocks are worth a close look.
