Secretary of Defense Mark Esper provided a rare piece of good news for U.S. shipbuilders Wednesday, saying he was committed to increasing funding for new ships as the Navy revs up for a new arms race in the Pacific.

Speaking at an industry conference, Esper said the Navy needs to build its fleet "in such a way that balances tomorrow's challenges with today's readiness needs, and does not create a hollow Navy in the process." And that, he said, means higher levels of spending.

"To achieve this outcome, we must increase funding for shipbuilding and the readiness that sustains a larger force," Esper said. "Doing this, and finding the money within the Navy budget and elsewhere to make it real, is something both the Navy leadership and I are committed to doing."

We've been hearing talk of a target to grow the Navy to 355 ships since the early days of the Trump administration, but we knew from the start that getting there would not be easy. Ships are some of the most expensive military purchases on a per-unit basis, and each new vessel put on the water then requires millions of dollars in annual maintenance and staffing costs.

An aircraft carrier flanked by support ships on the open ocean.

Image source: Getty Images.

All eyes on China

One driver of the Pentagon's desire to boost the size of the Navy is China's growing assertiveness in the Pacific Ocean.

In 1996, China had a surface fleet of 57 destroyers and frigates, but by 2019, that had grown to 355 ships, according to Washington think tank Center for Strategic and International Studies, making it larger on a strictly numeric basis than the U.S. Navy, which had 296 vessels in its deployable battle force.

China between 2014 and 2018 launched more subs and ships than the total number of ships currently active in the navies of Germany, Spain, and the United Kingdom combined, aiming toward a projected battle force fleet size of 425 by 2030.

Esper in his speech said that Pentagon "has prioritized China, then Russia, as our top strategic competitors," and said the U.S. needs a Navy able to police international borders and protect far-flung allies.

We need to rethink the Navy to get there

The Pentagon requested slightly more than $200 billion to fund the Navy in its fiscal 2021 budget, and with future Defense budgets expected to be flat to down, finding additional funds for the branch will be easier said than done.

Esper believes those funds could be freed up by making the Pentagon more efficient, and noted that last year, the Defense Department had identified $5.7 billion in potential efficiencies it could take advantage of. He also hopes to be given the ability to put any funds the Navy has left unspent at the end of each fiscal year into the shipbuilding account, rather than letting the funding authorizations expire. But Defense would have to come up with upward of $20 billion in new funds annually to fund ship construction at a percentage of the overall budget equal to what it was in the late Cold War period.

Another part of the answer will be autonomous ships, which could cost as much or more to build, but should offer significant operational savings over time. As a rule of thumb, assume 30% of a ship's cost is procurement and 70% is operations and sustainment, so a ship that costs $1 billion to buy would cost the Navy $3.3 billion over its lifetime.

The autonomous U.S.S. Sea Hunter turns away from port.

The autonomous U.S.S. Sea Hunter. Image source: U.S. Navy photo by John F. Williams.

The Navy is investing billions into autonomous ship research, last year awarding 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 limited human intervention.

In that sense, the fleet expansion talk is both an opportunity for and a threat to incumbent shipbuilders General Dynamics (GD 0.54%) and Huntington Ingalls (HII 1.82%), which combined soak up a significant part of the Navy budget. Boeing (BA -1.75%), a name usually associated with the Air Force rather than the Navy, is the lead contractor on the unmanned sub. Defense IT specialist Leidos Holdings (LDOS -0.64%) is behind the autonomous ship.

A rising tide would lift all boats

That's not to say traditional defense contractors are at risk of seeing their businesses dry up. Part of the reason the Navy needs to scramble to find funds is that a single General Dynamics program, the Columbia-class ballistic missile submarine, is eating up such a large portion of its budget. Huntington Ingalls, meanwhile, is the lead contractor for the U.S. nuclear carrier fleet refresh, with 10 ships planned at a cost of more than $10 billion apiece.

The challenge, however, has been identifying opportunities for these companies to grow. Over the past three years, Huntington Ingalls, which is a pure-play shipbuilder, and General Dynamics, which has other businesses but leans on Navy contracts for a large percentage of its revenue, have underperformed both the broader defense index and defense primes focused elsewhere.

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Defense stocks data by YCharts

We've known for years the Navy wants more ships. A big issue holding these stocks back is the concern the Navy's pocketbook can't keep up with its ambitions.

Esper in his speech laid out a blueprint for where the money might come from, but we're going to have to see action, and not just words, from the Pentagon and Congress before investors really have reason to get excited. Still, for these beaten-down defense stocks, his comments were the most positive news to surface on shipbuilding in some time.