© (LM Otero/AP Photo) FILE - In this July 7, 2006, file photo, the Lockheed Martin F-35 Joint Strike Fighter is shown after it was unveiled in a ceremony in Fort Worth, Texas. Shares of Lockheed Martin fell Monday, Dec. 12, 2016, as President-elect…
President Donald Trump's push for more military spending bodes well for defense contractors, but it's unknown which names in the space are most likely to benefit.
The bullish point of view is that Trump's call for more troops, new ships and new planes will increase defense spending. "President Trump will end the defense sequester and submit a new budget to Congress outlining a plan to rebuild our military," the White House website says.
At the same time, Trump has used Twitter to criticize the costs of Lockheed Martin Corp.'s (ticker: LMT) F-35 fighter jet and Boeing Co.'s (BA) next generation Air Force One, prompting some concern about defense company margins.
While the market is correct to believe defense spending is headed higher, some stocks will benefit more than others, and not all the spending will flow to contractors, says Morningstar analyst Chris Higgins.
However, with 2017 spending not finalized and the 2018 budget request not yet made public, "everyone's still reading the tea leaves," Higgins says.
The military budget includes personnel costs such as salary and benefits, operations and maintenance of facilities around the world and the development and buying of weapons. It's this latter part that investors should pay particular attention to, as much of the research and development and procurement money flows to contractors, says Credit Suisse analyst Robert Spingarn.
Former President Barack Obama's fiscal year 2017 budget request for the Department of Defense was about $580 billion, but Credit Suisse expects Trump to add $26 billion to $30 billion to the finalized 2017 budget.
Defense stocks have also been rallying in hopes of boosted spending in the fiscal year 2018 budget request, as well as the general pro-national security tone of Trump's campaign and administration, Spingarn says.
Even though the market has priced in quite a bit already, there could still be some buying opportunities, Higgins says.
If there is disappointment in the finalized 2017 budget and the release of the 2018 budget request, some of the stocks could pull back, he says.
But even if the budgets come in lower than expected, there could still be growth, he says. And for those willing to research and who know the defense industry, there could be pockets for longer-term investors that not everyone in the market is paying attention to. "These budgets are not exactly easy reading," Higgins says.
However, another side to the Trump administration is that he may push the contractors for lower prices on certain products, Spingarn says, noting Trump's tweets about the price of the F-35 and Air Force One.
When prices come down, particularly on products where volume is important, companies could see lower margins, Spingarn says. "We call Trump a potential double-edged sword," he says. "While he's busy spending more money he's also asking for lower prices."
Buckingham Research Group analyst Richard Safran, however, doesn't think Trump's policies will pressure margins, noting price reductions were already planned for the F-35 even before his tweet. "I don't think he is going to attack margins," he says.
While there is potential for slightly greater pricing pressure on future contracts, the large prime contractors are shielded to a certain extent from attempts to cut into their margins because there are few companies able to compete for the unique products they can provide, Goldman Sachs analysts say in a January note.
Additionally, the sector on average is still attractive even with lower margins, the analysts say. But if margins do come under pressure, companies with less prime contracting work such as L3 Technologies (LLL), Harris Corp. (HRS) and FLIR Systems (FLIR) "could be more attractive to the investor concerned with headline risk."
The Defense Department's priorities will benefit contractors with more exposure to land forces of the Army and Marine Corps., particularly General Dynamics Corp. (GD).
Trump's push for ship building also bodes well for General Dynamics, as well as pure-play ship builder Huntington Ingalls Industries (HII). "Navy's going to be a big theme for defense spending under this president," Spingarn says.
He expects supplemental military spending will include ship depot maintenance and precision-guided munitions, which favors Raytheon (RTN) and Lockheed Martin in addition to General Dynamics.
Potentially more F/A-18 Super Hornets for the Navy would benefit Boeing – that Trump tweet about the F-35 said he had asked Boeing to "price out a comparable F-18 Super Hornet" – and more F-35s for the Marines would benefit Lockheed Martin, according to Spingarn. Orders for both would be a boon for Northrop Grumman Corp. (NOC), which works on both programs, he says.
By Matt Whittaker
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