We are at the beginning of another defense spend cycle, so in this episode of Industry Focus: Energy, Nick Sciple is joined by Lou Whiteman to give us the latest developments in the defense industry. We get a primer on how the entire process works. What are the big-ticket items, and which companies can benefit from them? Also, small contractors are increasingly playing a major role. We focus on one such contractor, Leidos (NYSE:LDOS), in detail.

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This video was recorded on Feb. 27, 2020.

Nick Sciple: Today is Thursday, Feb. 27th. We've got a great show planned for you today. I'm joined, once again, by Industry Focus contributor Lou Whiteman. Lou, welcome back on the show!

Lou Whiteman: Thank you.

Sciple: Is there anything going on in the stock market today, Lou? Have you noticed anything in your morning news reading?

Whiteman: I haven't been on Twitter; is anything going on?

Sciple: Yeah. So, I barely read a little bit, every major index in the U.S. is down over 2% this morning on coronavirus fears. This continues a trend since the past week. So, since last Thursday, when we last had the show, S&P is down 9.99%, as of I'm checking things right now. So, obviously, lots of volatility. I think CNBC would say, "Markets are in turmoil." Lou, when you see this sort of thing happening, how do you respond as an investor?

Whiteman: Well, you know, it's important to say, this is real and it's very serious, and it's tough to just stick to the financial perspective. But sticking to the financial perspective, there is going to be a material impact on a broad range of businesses through the first half of this year, maybe even into the second half, and that's just undeniable. I think it's important, as long-term investors, to say, I also haven't seen anything to suggest there will be a permanent material impact. And as hard as it is, you do need to keep that in mind as you're watching these headlines. To put a plug in, I would assume anyone listening to us also listens to David Gardner, but he does a really good job at addressing that in this week's Rule Breaker podcast. So, it's worth listening to, it's just to try and keep grounded for the long-term as all of these headlines play out. But the headlines are very frightening. It's not a fun time.

Sciple: Yeah, it's tough. I can say, myself, as an investor, you know, you see your stock's falling. And you may -- oh my gosh! Especially, as everything has been on their highs and you just get anchored to this high. It's just really tough to know how to respond, especially in this situation. I talked, maybe six months ago, we did a Halloween show and we talked about what scares us the most in the market and I talked about the repo stuff. So, I don't understand it. And I think what's going on with this virus is something, as a regular person, it's really hard to understand exactly what's going on, even the CDC experts are still figuring out what the truth is on the ground. So, you know, try to --

Whiteman: Yeah. It is a work in progress for them. They're learning as they go and that's not settling for us non-medical people to hear. You know, you like to think that doctors have it all under control. I think they will get it under control, but yeah, it's scary times.

Sciple: Yeah, but still to remember, you know, these things have happened in the past, we talked about SARS, we recovered just fine. I think things will be fine over the long-term, but keep in mind that you think long-term. And take care of yourself, wash your hands, do everything you can to keep yourself healthy and that'll be good for everybody.

As we said, we got a great show planned for you today. We'll be diving into the defense industry, we got a tweet from one of our listeners, DJ Joey Hayes asking us to dive into this, so that's what we're going to do.

You know, if anybody else at home has any other show topics want us to dive into, don't hesitate to tweet us. Shoot us an email at IndustryFocus@fool.com and we'll be happy to dive into that.

On the back half of the show, we will be diving into Leidos, which is the largest IT business in the defense industry. But first, the big news right now is the latest defense budget. Before we dive into the budget itself, Lou, how does this budgeting process actually work?

Whiteman: Yeah, it's important for investors interested in defense to kind of get a primer on the process. What we saw a couple of weeks ago, this is the Pentagon has submitted their annual budget request to Congress, this is not the final document, this is the first step in the negotiations. The Congress has the power of the purse. We're now going to start a period where there's going to be a lot of hearings, a lot of back-and-forth where Congress will eventually, hopefully by early fall, come up with a budget and allocate funds.

This is an important part of the process, because it gives us, kind of, insight into what the military planners are thinking, what they're prioritizing. It is important to look at, but at the same time, this is not a final spending document and you shouldn't necessarily trade off of any request you see on this. So, it's important to keep that in mind. This is a long drawn out process.

Sciple: And, Lou, one question I have when I'm thinking about the budgeting process and how the major defense contractors play into it. To what extent are there kind of governmental relations efforts on the part of these contractors to influence the budget to benefit their business?

Whiteman: Very much so. And you especially see it on the congressional side. This is why all these contractors have operations in 50 states. A lot of times the gamesmanship you'll see right now is, the Pentagon will actually, to try and get more bang for the buck, so to speak, they will lessen their request for popular programs, say the F-35, knowing full well that Congress people will be under pressure from the contractors to make sure that that goes up and, hopefully, it won't come at a cost to something else, so just raise the overall budget.

So, yes, especially on the congressional side, the lobbying comes in. And, yeah, this is how the sausage is made.

Sciple: Yeah, this is an important part of these businesses when their No. 1 contractor, customer is the U.S. government. And when we go into the budget itself, Lou, what really stands out to you in this budget proposal?

Whiteman: So, we're going to talk about three things today. First of all, we've talked about this on the show before, but the nukes. The nuclear triad is a huge Pentagon priority. Refreshing 1960s Cold War combination of bombers, submarines, and missiles. They're due for an upgrade. It is a very expensive process; $400 billion or higher over a 10-year period. We're not going to do it all in one year, but that was a big priority in this budget. $45 billion in total spending for nukes, spread across $4 billion for a new ballistic submarine, that's a General Dynamics program. We have almost $3 billion for the B-21 bomber, which is Northrop Grumman. And then another $1.5 billion to replace the intercontinental ballistic missile; which is still up for bid but is likely to be a Northrop program.

The money has to come from somewhere for that. We've seen cutbacks in shipbuilding, cutbacks in other areas. But this is a big priority. This is probably the No. 1, the cornerstone priority for the Pentagon, and they are determined to get it funded in a big way.

Sciple: Yeah, Lou, obviously, you know building nuclear weapons is always a controversial prospect. I did some research, when you look at nuclear power in the U.S.A. and the average nuclear reactor in U.S.A. is 38 years old. It's just so controversial to build a new nuclear reactor, a power plant. When we look at our nuclear arsenal today, we compare that to the 38-year lifespan of the average nuclear reactor, is that the kind of age we're thinking about with our nuclear arsenal or how should we think about that?

Whiteman: The current missile, the Minuteman-III, was first deployed in 1970. So, that is a plus-50-year-old technology. And I would add that that was an update on the Minuteman-I and Minuteman-II, which was a lot older. So these were not even clean sheets in 1970.

There is some controversy about how much of this we need, but it is pretty much central to U.S. foreign policy doctrine is, we needed a deterrent. The reason our homeland will not be attacked is, if you attack us, you can take out the missiles, but we've got subs, you can take out the subs, but we have bombers. This three-pronged approach is our deterrent. It is our No. 1 defense priority.

And the details, you can squabble on, do we need it all, do we need it in the volumes that the Pentagon wants? That is a debate, but this will get done. It is an overriding priority and the pushback to the concept is only in the fringes.

Sciple: Yeah. Lou, when you talk about deterrence, you know, I need to have nukes because these other people have nukes. You think about great power conflict, China, Russia, these types of countries and that's part of this budget as well, right?

Whiteman: Yeah. That's the second big thing to hit on. Now, for the last 20 years or so the focus of the Pentagon has been on battling mostly insurgents or small armies in the desert, that is changing, there is an increased focus on China and on Russia. And that means a rethinking of the equipment that we need. There are winners and losers there. The army is getting very serious about modernizing, especially in the helicopter area. We're using Cold War era helicopters, that's going to be a big spending push. The other side of it is, we are going through an expensive process of replacing all of our Humvees, basically because the Humvees didn't perform as well in the deserts, they didn't perform as well with landmines. That you're seeing fall off as a priority. We're still replacing land vehicles, but what seemed like a priority five years ago, isn't.

So, there are winners and losers there. Definitely the Pentagon is more focused on Russia and China then they are in the Middle East, for the first time in a couple of decades.

Sciple: Yeah, Lou, when you mention these winners and losers here, what are the companies we should be thinking about that are the big winners here and then vice versa on the losers?

Whiteman: For great power, I would say, Lockheed Martin to some extent and Textron, with its helicopters. This is going to be hopefully -- Textron, needs a good year, and Textron needs its defense side to come through. Their Bell helicopter unit or Bell unit has a lot of very innovative designs that are key to the army's modernization. This isn't going to play out in calendar 2020, but you're going to see progress this year. I think Textron is going to be a finalist on one, perhaps, two, huge multi-billion-dollar programs for the army and that's going to be a hopefully a much-needed boost for that stock, because that stock has gone nowhere for a few years.

On the other side, I mentioned the Humvee replacement, that's an Oshkosh program, Oshkosh isn't a company you might think of as a defense contractor, but it's an important part of their business. It's not going to go away, but I doubt it's ever going to hit the long-term $30 billion or so spending total. So, there is going to be a slow drawn-out hit there for them.

Sciple: OK. And then this third, kind of, leg of the stool that you mentioned of this budget, comes into the tech arena, modernization of how we fight warfare. Can you dive into what that entails?

Whiteman: A big part of that -- and we've talked about this before, I think -- is what they call hypersonic missiles. These are missiles able to travel more than five times the speed of sound. It is perceived, and it seems with some evidence, that China is out ahead of us here and Russia is out ahead of us here. And that is very unnerving, because we do not have the capabilities to defend against these sorts of missiles right now. The Pentagon is earmarking $3.2 billion for hypersonics. There's also a huge request -- about $3 billion -- for AI and autonomy, and about $10 billion for cyber. These are areas where there is perceived vulnerability or there is perceived that we are, if not behind, we're not in the lead, and the military is getting very serious about those areas.

Sciple: Yeah, I think, just the concerns we've had around the elections the past few years in the cyber arena has definitely raised red-flags for folks, the concerns -- what's going on here. When I think about the intersection between technology and defense, what's been in the news a lot the past few weeks and months is this Amazon/Microsoft JEDI contract with the Department of Defense, that Microsoft had won and now Amazon is challenging.

I think, we're seeing over the past several years, increasingly big tech becoming more interwoven in these types of government contracts, defense business, how should we think about that growing over time and big tech becoming a bigger and bigger government contractor?

So, there is definitely, we're at a crossroads between tech and defense, and you see this in the platforms, the use of AI in drones, autonomous ships, autonomous vehicles. Tech is becoming more and more important in defense, just as it's becoming more and more part of our world.

I think contracts like JEDI are more of an exception than the rule. JEDI is a huge push to put Pentagon IT systems in the cloud. Cloud is an area where these big tech companies have an advantage and they have the infrastructure, so it made sense for them to get involved. But every time we've seen commercial businesses get into defense, they've stumbled a lot more than they thought they would. And I think you're already seeing this on the employee level with some of the pushback we've seen at Google and Microsoft and Amazon. We're also seeing kind of a clumsiness in how these companies handle the procurement process, which I think will hold them back.

I don't see a lot of JEDI contract -- I think defense contractors will continue to soak up a lot of the revenue. Even in JEDI, a company called SAIC, just announced a $1.2 billion deal basically because they want more manpower because they're going to be on the ground implementing JEDI. I think these companies are still going to soak up the lion's share of the revenue.

But, yes, you are seeing this intersection and there's going to be more interplay, because the Pentagon is very interested in tech's capabilities; as they should be.

Sciple: Yeah, it sounds like you're saying, Lou, like we said off-the-top, how important governmental relations is in this industry. Understanding your customer in the U.S. government in-and-out and being able to provide to them exactly what they want, to their specifications, that sort of thing. When you look at this trend, is there a company in defense that you'd be most excited in to follow or invest in to play into that trend?

Whiteman: No, I think just to emphasize that point. I think that is maybe the most misunderstood part about the defense sector, that dealing with the government is a core competency and it's not something easily done. I mean, it works the other way. These contractors, most of them have failed miserably when they've gone out into the commercial sector. It's a different animal and it's very much underappreciated how important it is to know how to deal with the government.

Among big contractors, for a lot of reasons, I like Lockheed Martin a lot, they're involved in a lot of the tech emphasis areas and they just have an amazing portfolio. A company that we're going to get into in a second, but Leidos, I think, is at a real pivotal movement, they're at a crossroads of what's going on here, but we'll talk about them in a second, but there's a lot to like here even though we might be hitting a peak budget.

Sciple: Yeah, before we get into Leidos, I want to make sure to remind listeners, if you're just starting out or you know someone who's looking to get started investing, we have a free investing starter kit. It covers everything from saving money, to 401(k)s, to buying your first stock and it includes five stocks selected by our investing team for free. Just go to fool.com/starterkit to check it out. That's one again, fool.com/starterkit.

All right, Lou, you mentioned, Leidos is an exciting company to kind of play into this techification of the defense industry, if you will. What should we know about this business, what does it do?

Whiteman: Yeah, let's talk about government services for a second. I mean, most people, when they think defense, they think big hardware items, bombers, tanks. There is a large and growing business running IT networks, doing research, as the name implies doing services for the government. This is a growing business, because we're in an age of low-taxes, we're in an age of deficits. The government increasingly, Pentagon and civil agencies, need to do more with less. And their answer is outsourcing, for lack of a better word. It's a trend that is only going to continue.

Leidos is a big part of that. Company was formed out of a spin off in 2012. It's gone from $6 billion revenue to $10 billion in less than a decade. A lot of that via M&A. It's a business that is, both, intriguing for all of the trends I just mentioned, the outsourcing, it's a business that's going to grow, but it's also, by the nature of it, at the end of the day, a lot of times they're fighting on costs, which leads to a fight to the bottom and means margin pressure. So, it's a business that's both exciting, growing and challenging for these companies and they're trying to figure out how to get it right.

Sciple: Right. And so, when I think about margin pressure and you think about these contracts that defense contractors bid for, you know, the lowest price wins. So, I think one important aspect that I think about is what are the barriers to entry into this segment of the market? So, when Leidos gets a contract, how easy or not easy is it for another competitor to come in and then displace them from that position with the government, how hard is the changeover, that sort of thing?

Whiteman: The contracts are typically multi-year, and they typically have extensions. You can't break that during the contract, but when they come up for recompetes, those tend to be wars. Leidos just won a huge $7.7 billion IT contract with the navy that they stole away from one of their competitors.

It does happen, there is an incumbent advantage, simply because a lot of these contracts here are so embedded with the customer, there is a huge switch cost, but you do see it. And increasingly these companies, the bigger companies, they have scale advantage and they are going in and offering a lower cost and they are trying to win that business. There is more business coming, but the easiest way to grow is to steal something from someone else and so, yeah, they are very actively trying to do that.

Sciple: Right, I mean, you mentioned this pressure on margin, scale is important. Are there any new business lines they might be pursuing to kind of grow the pie of what the business, you know, their addressable market that sort of thing?

Whiteman: This is where Leidos gets really interesting. They have been a government services contractor for most of their history. They have done a good job expanding into areas like intelligence, using their scale advantage, using the number of employees they have with these clearances. These clearances can take a long time to get, a year, a year-plus to get a new employee with clearance. That is a huge barrier of entry to a commercial firm trying to come in and run an IT network. They've also done a good job capitalizing on the techification of hardware and finding areas to compete. Last year a ship traveled from Sanbuild the ship, but they were responsible for the electronics and the brains in it. That is a new area where 20 years ago, you couldn't see a mostly tech company compete where they can compete.

They are very exciting right now, because since Christmas, they have done two $1 billion deals to kind of build up their research and hardware. In late December they bought a privately held company called Dynetics, that is a research shop based in Alabama. They have very close ties to NASA, they are very much involved in the intelligence community and they have contracted a prime contractor on something called Gremlins, which actually imagines an airborne -- almost think of it as an aircraft carrier, launching drones and recovering drones. This is a very futuristic company involved in hardware to some extent, but it's a brand-new business for them. They also bought an airport scanner business from L3Harris, which again, is an area where electronics and equipment sort of overlap.

So, they are really forward-thinking. They are really looking at how they can build this business and kind of avoid the economies of scale race to the bottom trap. And you know, it's still early, but it's very exciting what they're doing.

Sciple: Yeah, you mentioned Dynetics, Alabama. I'll tell you, just from talking to folks back home, the defense industry in Huntsville is just absolutely exploding. That's a huge, huge growth area. One thing that you mentioned, this ship where they kind of run the brain of the ship and then another contractor maybe builds the ship itself; makes me think about, you know, in self-driving, we heard early these arguments that Waymo and these other companies are going to run all the brains of the cars and then we're going to turn the OEMs into the kind of the Foxconn of cars. And maybe that dynamic hasn't played out quite the way we expected in self-driving cars, but when you look at what's going on in the defense industry with Leidos, is that a comparison that makes sense? You know, turning the other defense contractors, in this instance, into kind of a Foxconn and then they're running the brain of the technology behind the scenes.

Whiteman: There's probably going to be something of a hybrid approach and we're already seeing that. Huntington Ingalls, which is one of the two largest shipbuilders, and the company most reliant on shipbuilding. They have partnered with Boeing on an autonomous sub, where they are actually building the sub. So, you are going to see some of that, but truth is, there's a lot of low-margin shipyards out there where you can build a boat. The Leidos autonomous ship, for example, was built without Huntington or General Dynamics, which is the other big shipbuilder. That at least, suggests the opportunity for some of the Apple-Foxconn type relationships, and that is a real threat to shipbuilders. One, I think I should add, that they are aware of, Huntington Ingalls has been buying up autonomous, trying to get stronger in autonomous. I don't think it sinks the shipbuilders, pardon the pun, but it is a new dynamic where it was a pretty private club ten years ago, it's not such a private club anymore. As the navy evolves, there are going to be new companies involved and it's something that definitely investors and the shipbuilder should be mindful of.

Sciple: Yeah, I'll say. My step dad actually works for Huntington Ingalls, so you know, I'm rooting for him, but you know this is a real concern. But when you look at Leidos and you look at the defense contract industry, a lot of people gravitate toward Lockheed Martin, Northrop, General Dynamics, these big contractors. What does a company like Leidos give to investors that differentiates them from what you might get from those big giants?

Whiteman: I should say, I'm still very excited about some of the defense primes. I mentioned Lockheed before. General Dynamics, for kind of commercial reasons, I think that stock still looks attractive. With Leidos though, as I've said, it feels like they're at a tipping point. They along with, maybe a company called L3Harris, I think, have the real potential over the next couple of years to turn into something much bigger, much more important to the defense landscape.

And you know, it appears we're reaching the kind of peak budget for this cycle, it's going to be harder for the defense primes to show growth with new awards. A company called Leidos, they've taken a lot of debt short-term, and the stock has run-up pretty well. So, in the next few quarters maybe there's some choppiness, but they're on to something here and there is a real potential for them to show an outsized returns, I think, as they grow into this. And you just don't see those sorts of opportunities in the defense business elsewhere right now at this point in the cycle.

Sciple: Right. I think the way you described how technology is continually being integrated, you know, with defense, how much more important cyber is becoming as part of our defense strategy. This is the wave that is just growing. I just can't see that stopping anytime over the next several decades, whether Leidos or somebody else is going to be the winner, this is a huge trend that is just got to continue, right?

Whiteman: I agree. And I think everybody -- this isn't a secret to anyone in the industry, and you see a lot of the companies bulking up in various parts of technology. There are some great R&D shops in this industry, everybody will ride this wave. But, you know, this is a group of stocks that tend to trade in a group, they tend to trade based on the budget, based on macro factors. It's tricky to find outperformance. And I think with these companies that are sort of just coming into their own, that's where you're going to see outperformance, as they sort of grow into the upper echelon that the primes are already in.

Sciple: All right, folks, that's an exciting one to add to your watchlist, and an exciting industry to just watch in general as the techification of defense continues to play out. As that happens, Lou, I'm sure we'll have you on again soon to discuss it and dive into it. So, I hope to have you again soon.

Whiteman: Looking forward to it. Thanks for the time.

Sciple: As always, people on the program may own stocks discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks mentioned, so don't buy or sell anything based solely on what you hear.

Thanks to Dan Boyd, for his work behind the glass. For Lou Whiteman, I'm Nick Sciple, thanks for listening and Fool on!