Defense stocks have done well over the past five years, fueled by a steady increase in Pentagon spending. Washington's next round of budget negotiation is likely to be contentious. Motley Fool's Nick Sciple and Fool.com contributor Lou Whiteman discuss the outlook for defense spending in fiscal 2020, and why this is the biggest issue overhanging the industry on this segment of Industry Focus: Energy.
A full transcript follows the video.
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This video was recorded on Jan. 31, 2019.
Nick Sciple: With this shutdown lasting for as long as it has, it really highlights the divisions between the two parties in Congress and this inability to come to an agreement. When you look at the 2020 budget, those two groups reaching an agreement as to how much money we're going to spend on defense and the rest of the government is really important to the thesis for these defense contractors. Can you talk about the uncertainty of what we're looking at into the 2020 budget, and how we should think about that as investors?
Lou Whiteman: Yeah, very much so. This is something investors have to be watching. To give you a quick history, right now, we're still working under the Budget Control Act of 2011. If you remember back to the previous administration, we had a split government, and they weren't doing a great job of coming to an agreement on things like budgets. Lawmakers passed a law basically saying, "If you can't compromise, then on both the defense and the civil side, there's going to be sequestration," which was a massive, across-the-board cut. That actually went into effect. It was not enough of a threat to force them to compromise. Defense stocks were hit pretty hard during that time.
With the new administration, we had a couple of years of unified government. We had a two-year budget deal that included Pentagon funding. That's why they weren't part of the shutdown. A lot of people don't realize, that was only a two-year deal. We're coming up now on fiscal 2020 without a new compromise. We're going to revert back to those sequestration levels. I've seen estimates all across the board, and there's a lot of accounting tricks you can do, but this could cost the Pentagon upwards of $100 billion in spending per year. They can't stop paying the troops, so a lot of that is going to be deferred procurement or deferred modernization of IT.
This recent shutdown was the appetizer to the main course, which is that 2020 budget. Seeing how that played out, it's really hard to have a lot of optimism right now that the budgeting process will go smoothly. Hopefully, they can eventually get something done. I'm not predicting we're going to return to sequestration, but it's a huge risk. It's something you have to be watching. Long-term, I think the companies will be fine. Long-term, as we'll talk about later, there are a lot of things that need to be done, a lot of spending that needs to be done. But, this could certainly impact 2019 spending. It could certainly even go into 2020 if the deal is reached late, if there's uncertainty, or if they kick the can and projects have to be delayed.
Sciple: If we go into sequestration, what kind of adjustments might these big contractors have to make to their operations to absorb that and wait out the low times until we can reach another consensus in Congress?
Whiteman: How they modeled it last time -- and unfortunately, they have recent history here -- a lot of the big needle-moving projects for these companies, they're not going to disappear. We're not going to stop buying aircraft carriers, we're not going to stop buying F-35s. They can sort of proceed as business as usual, although they might have to slow the scale or slow productivity. For near-term results, for quarterly results, it creates ugly comparisons, and it definitely slows the business down. You have to be a long-term investor to weather that storm. What we learned last time, and I think we'll learn this time, is that in the end, there will be a resolution. But really, what we saw is these companies that just did what they could on the expense side and slowed production to levels that they thought the government was going to order.
The real companies that got hit are, we like to call them the Beltway bandits, the government IT companies that are increasingly important. A lot of the IT is being outsourced by the government. Those projects are the ones that were really easy to bring to a halt. I would anticipate those companies -- SAIC being one; Leidos is a huge one -- those are the companies that are going to be the hardest hit if we do indeed hit sequestration again.