After years of pinched revenue and contract delays primarily due to budget battles in Washington, D.C., the fiscal 2016 budget proposed by the White House this week is a signal to the industry and its investors that it is once again time to focus on growth.
President Obama proposed spending $534.3 billion on defense during the government's fiscal 2016, an amount $38 billion above last year's request. The number is far from certain — the sequestration-mandated defense budget cap for the year is $499 billion — but with Republicans in control of both houses laying on rhetoric about the need to strengthen the military, defense firms are feeling optimistic.
Much of the focus of the budget is the Pentagon's desire to play catch-up on defense modernization, which means more spending on big ticket items like planes and warships. Meanwhile, funding for Overseas Contingency Operations, a placeholder outside of the base Pentagon budget to fund war operations, is officially down by $13 billion to $51 billion but international tensions will likely push that number up in the months to come.
Defense analysts see two categories of winners in the budget. The most immediate could be government services firms that have been hit the hardest by sequestration and troop drawdowns. Any overall uptick in spending would flow first to companies like ManTech International (MANT) - Get Report and Leidos Holdings (LDOS) - Get Report as there is less lead time needed for maintenance and related services than there is for new warship procurement.
Increased hostilities in Syria or elsewhere in the Middle East could also benefit these companies, even if spending levels do not return to the wartime levels of the last decade.
Longer term, much of the emphasis of the budget is aircraft purchases and shipbuilding, with ground systems and missiles and munitions lagging behind. If so that would leave a group including Boeing (BA) - Get Report , Lockheed Martin (LMT) - Get Report , Ducommun (DCO) - Get Report , Esterline Technologies (ESL) and Triumph Group (TGI) - Get Report as primary beneficiaries, with Raytheon (RTN) - Get Report and Textron (TXT) - Get Report among the names likely to see smaller increases.
An uptick in optimism should also fuel increased consolidation in what has been until recently a deal-happy sector. The Pentagon since the late 1990s has warned against dealmaking among its largest prime contractors, eager to preserve competition. But over the last decade a large crop of second tier firms including L-3 Communications (LLL) - Get Report , Huntington Ingalls Industries (HII) - Get Report and TransDigm Group (TDG) - Get Report have emerged as potential buyers or sellers in the years to come.
The most interesting company to watch could be Northrop Grumman (NOC) - Get Report , which raised some eyebrows last month when it named Brett Lambert, a former U.S. defense official who advised on industry M&A, to oversee corporate strategy. Northrop has suffered a series of contract losses in recent years, and analysts say it is the most likely to test the Pentagon's resolve on prime consolidation.
Company officials have dismissed talk of a deal with a fellow prime, but whispers of a potential cross-border merger between Northrop and a European rival like BAE Systems (BAESY) persist. If nothing big materializes Northrop seems likely to use smaller deals to augment growth.
Risks remain. Analysts note that lawmakers are almost certain to fully fund personnel requests, even if that means taking money from weapons procurement. But defense sources say even in that case appropriations for next-generation weaponry including the Long Range Strike-Bomber will likely be stretched out into future years and not abandoned entirely.
The new budget request, if nothing else, is a sign that things are starting to get back to normal in the defense patch. Anchors aweigh.
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