President Donald Trump's 2016 pledge to expand the Navy's fleet by 30% to 355 ships was celebrated as good news for defense contractors Huntington Ingalls (NYSE:HII) and General Dynamics (NYSE:GD), which together are responsible for most of the United States' shipbuilding capabilities.

Three years later, officials insist the Defense Department "remains committed to the 355-ship Navy." But the fiscal 2021 budget proposal includes a year-over-year decline in the number of warships to be purchased. And over the five-year budget projection, additions and retirements would keep the total number of ships about flat.

The Navy's aspirations have crashed into the cold realities of the budgeting process.

A submarine sales out to sea.

A General Dynamics Virginia-class sub in the sunset. Image source; General Dynamics.

The Pentagon is trying to rework the entire military to meet the threat of a great-power conflict with Russia or China, which involves revamping ground and air forces that for the past 20 years have been focused primarily on fighting insurgents in the desert. And although the new Columbia-class ballistic submarine is perhaps the nation's top priority, and sure to be funded, that program's estimated $115 billion total construction budget for just 12 vessels is pulling funds away from other ships.

On a recent investor call, Huntington Ingalls CEO Mike Petters described paying for the Columbia "the elephant in the room that has to be dealt with," costing the Navy the opportunity to expand more aggressively. Until the Columbia is further developed, and the total program cost is clearer, it is going to be more difficult for the Navy to commit to buying more ships.

General Dynamics and Huntington Ingalls are the primary contractors on the Columbia and have large-enough backlogs to ensure that their shipyards stay busy. But that hoped-for windfall of 355 ships now seems unlikely to materialize.

An autonomous future?

The Navy's spending woes go well beyond ship sticker prices. Each new carrier, destroyer, or submarine comes with substantial additional crew costs that compound over time. According to the Center for Strategic and International Studies, the Navy base budget grew by nearly 50% from 1997 to 2015 even while the fleet size shrank by 20%, raising questions about whether it would be possible to afford operating a vastly expanded fleet even if all those new ships were built.

The obvious answer is to focus on ships that don't need crews. The Navy is investing billions on autonomous research, and last year awarded a contract to construct four large unmanned submarines. It's also making progress with its surface fleet, successfully sailing an autonomous ship from San Diego to Hawaii and back in 2019 with little human intervention.

For the shipbuilders, autonomy is both an opportunity and a threat. The lead contractors on the unmanned sub and autonomous ship are Boeing and Leidos Holdings, respectfully, two names not normally associated with shipbuilding. Huntington Ingalls is providing the construction work on Boeing's Orca sub, but the shipbuilders don't want to end up as low-margin metal benders as more of the value, and money, flows to the electronics and software developers.

An autonomous sub underwater.

Rendering of Boeing's Echo Voyager (Orca) autonomous sub. Image source: Boeing.

Huntington Ingalls identified the move toward autonomy years ago, but much of the company's engineering focus at the time was committed to existing projects, including the Navy's new aircraft carrier. The company has responded by trying to build up its capabilities, including a deal announced earlier this month to buy marine robotics developer Hydroid for $350 million.

On the investor call, Petters said he believes that combining the newly acquired autonomous expertise with Huntington Ingalls' existing facilities, manpower, and manufacturing expertise will "accelerate the development of the unmanned space on behalf of our customer." And, presumably, give his company a one-stop-shopping advantage in winning future autonomous business.

That might be correct. But the Boeing and Leidos examples show that the disruption the Navy is experiencing as it tries to find new ways to grow the fleet could open doors to new competitors and end up eroding the advantages of Huntington Ingalls and General Dynamics as well-established shipbuilders.

Investors need to watch closely

It should be noted that the Huntington Ingalls and General Dynamics shipbuilding businesses are at no risk of drying up overnight. The estimated $20 billion warship request in the new budget, while down from recent years, is still well above the $14 billion to $16 billion annual figure Petters said he has seen through most of his career.

Significant funds are going toward the Columbia and the Navy's new carriers, but the service remains committed to buying mainstays including Arleigh Burke destroyers and Virginia-class attack subs well into the future.

The hard question is where the growth will come from. General Dynamics investors can fall back on the company's key role in the Army's modernization effort, as well as its rebounding business jet unit. Huntington Ingalls is more of a pure play tied to the Navy, and it's harder to make the bull case for the company without an expanding fleet.

Huntington Ingalls has already done one autonomous deal in 2020, and I'd expect the company to aggressively look for further acquisition opportunities to augment its capabilities and reshape its portfolio. That's likely a wise move, but it would create new integration risks and potentially prevent the company from returning substantial free cash flow to shareholders.

There is no reason for existing holders to abandon ship, but investors need to watch closely as these shipbuilders try to navigate the Navy's shifting priorities as the service aims to build its fleet.