Does War Mean A New Era for US Defence Firms?

The war in Ukraine and tensions with China are forcing the US to up its defence game, and its contractors are at the front of the line, primed for benefit

Jocelyn Jovene 21 February, 2023 | 10:33AM
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F16 fighter jet

Over the course of two years, the US defence budget will grow by nearly 10% to reach $813 billion (£671 billion), faster than the growth of the US economy.

The budget increase for the US Department of Defense (DOD), which is detailed in the FY 2023 National Defense Budget Request, reflects the threats arising from the war in Ukraine, the tensions with China and the emergence of local conflicts in the Middle East and Africa.

However, despite increased military spending, the performance of the largest US contractors has been far from spectacular.

Over the past five years, the Morningstar US Aerospace and Defense index has underperformed the Morningstar US Market index by a significant margin, as is made clear in the below chart.

One reason has been the massive underperformance of Boeing (BOE), which was embroiled in the controversy and subsequent grounding of its 737 MAX aircraft – before it was hit hard by the Covid-19 pandemic.

Morningstar’s Nicholas Owens, the equity analyst covering the stock, does expect Boeing to recover. This is largely due to the certification of its new 737 MAX-7 and MAX-10 aeroplane designs and the reopening of China, where it has recently returned to active service.

Demand on the Horizon

The rest of the industry fared slightly better, with cumulative gains between 39% and 80% over the past five years.

But the climate has not always been so favourable to these companies. Between 2009 and 2014, defence spending declined in the US, forcing the nation’s contractors to focus more on margin protection than business expansion. After 2015, the budget increased again, reflecting a growing demand for defence systems and a focus on China and Russia as rising threats.

A couple of M&A transactions saw the combination of Harris and L3 Technologies and the merger of United Technologies and Raytheon into Raytheon Technologies.

After the outbreak of war in Ukraine, the prospects of higher military spending and a growing profit pool are providing several opportunities for US contractors.

According to consensus data, the cumulative revenue of the six largest defence contracts Lockheed Martin (LMT), Raytheon Technologies (RTX), General Dynamics (GD), Boeing, Northrop Grumman (NOC) and L3Harris Technologies(LHX) is expected to grow 7.1% a year between 2022 and 2025.

Their net income is expected to almost double from $19 billion in 2022 to $34 billion in 2025.

Valuations wise, more solid prospects seem well priced in by investors.

The average EV/EBTIDA multiple for the largest US defence contractors currently stands at 16.6 times next twelve-months estimates, compared with 12.6 times for the US market.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

Jocelyn Jovene

Jocelyn Jovene  is Senior Financial Analyst and Senior Editor for Morningstar France.

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