Defense stocks lagged the broader markets in 2020 on fears that a new occupant in the White House, coupled with unanticipated pandemic-related stimulus, would crimp Pentagon spending.
Judging by the initial budget document submitted last week, those fears were overstated.
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On April 9, the White House proposed fiscal 2022 Defense Department spending of $715 billion, up 1.4% from the 2021 appropriation. When factoring in defense-related spending that is part of the Energy Department, the nation's total proposed defense spending would climb 1.7% from the prior year.
Not all of that goes to contractors, of course, and there are signs of strain in the details. Here's what investors need to know about the Pentagon's spending plans heading into the next fiscal year.
Flat is the new up
The spending plan is a disappointment compared to projections made just a few years ago. The $715 billion request, while up year over year, is below the $722 billion guidepost set by the Trump administration last year, and well below the 3% to 5% annual spending increases advocated by defense officials back in 2017.
Image source: Getty Images.
But investors were bracing for worse. On the U.S. presidential campaign trail, some candidates with a more progressive tilt were calling for 10% cuts to defense spending, if not more.
In that context, the $715 billion figure looks like a compromise that will please no one but should be able to muster enough support to win congressional approval. Importantly for investors, the proposal is a clear signal that the Biden administration has no desire to cut the way some progressives had hoped.
Sifting through the details
The spending plan released last week is a "top line" request, with a more detailed budget request on hold until later this spring. It doesn't contain an item-by-item spending list, but it does give some clear indications about what the White House sees as spending priorities.
Here's what we know:
- Focus on autonomous: The Pentagon in a statement said the budget is focused on making "key investments in technology," including supporting research and development and "optimizing" shipbuilding. That's good news for companies, including Leidos Holdings (LDOS 0.93%) and Kratos Defense and Security Solutions (KTOS 2.33%), that are developing new generations of ships and drones that are able to operate with zero, or reduced, crew levels.
- Hypersonics remain a focus: The Pentagon said "the need to counter the pacing threat from China" is a top priority, and mentions hypersonics, missiles that travel faster than the speed of sound, as an area of focus. A number of defense contractors, with Lockheed Martin (LMT 1.71%) and Raytheon Technologies (RTX 0.84%) leading the way, have identified hypersonics as a potential area of growth as the U.S. is seen to be lagging China in their development.
- Cyber won't suffer: The last time the Pentagon faced a flatlining budget, IT modernization efforts took a hit. That has led investors to shy away from IT specialists including Leidos, Booz Allen Hamilton (BAH 1.88%), and ManTech International (MANT). But cybersecurity, along with a need to counter efforts by adversaries seeking to "destabilize" the U.S., is a focus of the budget document. As I've said before, the Pentagon rarely makes the same mistake twice. It's unlikely that cyber will be cut drastically this time around.
- Legacy programs will pay the price: All of this investment will have to be paid for, and the Pentagon says it will "redirect resources" to top priorities while "divesting legacy systems with less utility in current and future threat environment." That's likely bad news for some of the ground equipment made by General Dynamics (GD 1.17%) and Oshkosh (OSK 0.05%), among other programs. After more than a decade of fighting insurgents, the Pentagon is now prioritizing so-called "great power competition" against Russia and China.
Be selective
The sky isn't falling, but the next few years will likely be tougher than the last few for defense contractors. Investors looking to buy in should focus on the companies most likely to hold up well under the strain.
I'd expect contractors that cater to the Air Force and space, including Lockheed Martin and Northrop Grumman (NOC 2.23%), to be stronger than those focused on the Army. And IT modernization efforts, if anything, are likely to increase in the years to come, which could fuel continued consolidation among defense services companies.
Leidos -- with a diverse offering including exposure to space, autonomous, and IT -- and space- and electronics-focused L3Harris (LHX 1.67%) look like intriguing picks for investors with a focus on the long term and the patience to ride out what could be a turbulent summer of budget battles in Washington.
