July 23, 2019

The Budget Deal Is Good News for Defense Stocks

Source: Barron's

Things are looking up for aerospace and defense companies.

United Technologies (ticker: UTX), Honeywell International (HON), andLockheed Martin (LMT) all raised their full-year earnings guidance when reporting second-quarter numbers over the past week. What’s more, United Technologies aerospace revenue grew 9% on a comparable basis in the second quarter.

If that wasn’t enough, the government just reached a new budget deal. That’s another positive—albeit a smaller one—for the defense sector.

On Monday, the administration and Congress reached a deal on fiscal year 2020 and 2021 spending, raising the debt ceiling to cover borrowing through July 2021. (U.S. federal government debt is about $22 trillion, which is borrowed from entitlement trusts as well as foreign and domestic investors.) The agreement calls for $738 billion in military spending in fiscal year 2020, with an increase in 2021.

“The deal also removes the threat of the fiscal year 2020 budget being sequestered under the terms of the Budget Control Act,” writes Vertical Research Partners analyst Rob Stallard in a Tuesday research report. “We view this development as positive for the defense sector, providing visibility on U.S. spending going forward.”

Budget sequestration limited growth in federal spending, which crimped military spending. From 2011 to 2015 total defense outlays fell by more than 16%. More recently, the industry has seen high-single-digit percentage point growth.

Faster growth has been good for share prices. The aerospace and defense components of the S&P 500 have returned about 17% a year on average over the past five years, better than the 11% return of the S&P 500 over the same period.

Of course, the budget deal still has to pass. “The main opponents of the deal so far are House Republicans, and while the president’s comments have been supportive, he did not say explicitly that he would sign it,” writes JPMorgan analyst Seth Seifman in a Monday research report. “Budget clarity [would be] a nice positive for defense stocks; however, we do not believe the market has been especially focused on budget-related downside in recent months.”

There is other good news which can serve as a catalyst for defense stocks, including strong earnings, new M&A activity—United Technologies plans to merge with Raytheon (RTN) in 2020—and, unfortunately, ongoing global conflict. Valuations aren’t high by historical standards: Large defense contractors trade for a little more than 14 times estimated next year’s earnings, a 5% discount to historical averages and a 5% discount to stocks in the Dow Jones Industrial Average.

All this means defense should continue to be a good investment in the foreseeable future. Wall Street agrees. Vertical’s Stallard, for instance, covers 21 aerospace and defense companies and rates 14 of the stocks Buy.

Stallard’s top pick is L3Harris Technologies (LHX). He argues that the shares are worth $208, about 7% higher than recent levels.

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