Now that the 2023 fiscal year budget for the Pentagon has been set at a record $858 billion, it is time to take a look at opportunities for investors to share in the good times.
There are concerns in some quarters related to the concessions new House Speaker Kevin McCarthy had to make in order to gain his position. For fiscal 2024, McCarthy agreed to demands that tie an increase in the U.S. debt ceiling to cuts in discretionary spending and, more important to the Pentagon, a cap on the 2024 defense budget at the same level as fiscal 2022, about $75 billion below the 2023 level. Either of these could lead to a government shutdown, a full-year continuing resolution for FY 2024 or a default on the U.S. debt. The latter is virtually unthinkable, but the other two have historical precedents, neither particularly pleasant.
And good times they are. According to Michael Ciarmoli and his team at Truist Securities, “[T]he demand environment and global spending backdrop for the defense sector is the best we have seen on record.” Defense spending will not be subject to congressional wrangling over a continuing resolution, and even a divided Congress cannot do much to change that.
Truist’s analysts anticipate a 5% to 6% compound annual growth rate in NATO defense spending through 2026 as a reaction to the Russian invasion of Ukraine. That is expected to drive growth in sales to foreign governments and backlog growth for U.S. defense contractors.
A recession, or something that closely resembles one, is among the assumptions Ciarmoli and his team make. Others are continuing inflation and supply chain challenges at least through the first half of 2023. The defense sector, they believe, has been “de-risked, supply chain headwinds will ease and are in no way an indication of structural pressure, and top/bottom line growth will accelerate given the spending backdrop.”
In a cautionary moment, the analysts warn that “putting new money to work ahead of 4Q22 earnings season poses an unnecessary risk.” They also note that they do not expect to change ratings “abruptly or frequently” this year and believe that “investors should employ a trading mentality given current conditions.”
From their coverage universe, Truist’s analysts call out three defense stocks and two aerospace aftermarket suppliers as favorites. Here is a brief look at each.
Since the L3 and Harris merger in 2019, L3Harris Technologies Inc. (NYSE: LHX) has striven to become the sixth U.S. prime defense contract, joining Lockheed Martin, Raytheon, Northrop Grumman, Boeing and General Dynamics in an elite group. Its offer last month to acquire Aerojet Rocketdyne for $4.7 billion ($58 per share) could do the trick. If completed, the deal would create a company with a market cap of around $45 billion.
Truist has raised its price target on the stock from $258 to $264 (the average of 20 analyst firms is $264.67) and maintained its Buy rating on the shares. Excluding the effect of the pending acquisition, Truist raised its 2024 earnings per share (EPS) estimate on the shares to $12.98. Including an estimated $1.88 in Aerojet EPS for that year, the combined total would be around $14.90 compared to an estimate of $12.78 for L3Harris alone in 2023.
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