Citi cautions clients about chasing defense stocks at these levels even with Trump's big spending plans

Published Wed, Mar 1 201710:58 AM ESTUpdated Wed, Mar 1 201711:14 AM EST

Citi Research on Wednesday cautioned clients about chasing defense stocks at the current levels, citing stretched valuations and limited upside potential despite expectations for higher military spending under President Donald Trump . The firm downgraded Northrop Grumman and General Dynamics to neutral from buy. "After nearly seven years with a positive bent on defense stocks we are now turning more neutral on the group," equity analyst Jason Gursky wrote in a research note. "This shift is driven by a potential disconnect in investor expectations for industry growth & by potential pressure on historic business models. We don't think the sector underperforms indices going forward per se; it's just that it's reaching fair value," he said. The report was released after White House officials on Monday told reporters of a budget proposal calling for a $54 billion increase in defense spending next year. In a speech to Congress on Tuesday night, Trump called for one of the largest increases in defense spending in American history. Given expectations of what the new administration might be able to accomplish, Citi says defense stocks have already run up, and are now trading at multiples the firm considers to be "aggressive." iShares U.S. Aerospace & Defense ETF ( ITA ), 1 year Source: FactSet "We're concerned the market expects too much, too fast when it comes to industry growth. We've long argued that defense should price in 3% perpetual growth which reflects the long-term average. For the last six years stocks have consistently priced in less, supporting our Buys. But some now reflect 4%+ growth, which looks aggressive in a historical context," Gursky wrote. In the near and midterm, Citi analysts think the outlook for defense stocks remains challenged due to budget constraints, slow procurement processes and low threats of wars that would justify Trump's urgency to build up what's already one of the biggest arsenals in the world. "We have long argued that the threat environment is the major driver of defense spending. But, not much has changed on this front since the election," Gursky said. Citi believes the U.S. will continue to plan spending budgets above the sequester caps, as it was done during the Obama administration, but this time, Trump is likely to "take credit for pushing through bigger budgets." "We don't think those budgets will be materially beyond what his predecessor was already planning for. This suggests that low- to mid-single-digit growth is still the likely outcome for domestic defense sales," Gursky said. Apart from lower-than-expected military spending, Citi says the industry's business model is changing, as defense companies face pressure to innovate and reduce costs through capital spending. "This introduces more risk into prime contractor business models as R & D [research and development], capex & fixed price contracts all rise," Gursky said. In his note, the analyst reduced his 12-month price target for Northrop Grumman to $275 from $285, capping the upside potential at 11 percent from Tuesday's close. The 12-month price target for General Dynamics was kept at $202, implying a gain of about 5 percent from here. Over the past 12 months, shares of Northrop Grumman and General Dynamics are already up 28 percent and 38 percent, respectively. — CNBC's Michael Bloom contributed to this story.

F-35 Bravo Lightning II stand ready on the deck of amphibious assault ship USS Wasp for day two of the first phase operational testing in the Atlantic Ocean in this handout photo taken May 19, 2015 and provided by the U.S. Navy.

U.S. Navy | Reuters

The firm downgraded Northrop Grumman and General Dynamics to neutral from buy.

"After nearly seven years with a positive bent on defense stocks we are now turning more neutral on the group," equity analyst Jason Gursky wrote in a research note. "This shift is driven by a potential disconnect in investor expectations for industry growth & by potential pressure on historic business models. We don't think the sector underperforms indices going forward per se; it's just that it's reaching fair value," he said.

The report was released after White House officials on Monday told reporters of a budget proposal calling for a $54 billion increase in defense spending next year. In a speech to Congress on Tuesday night, Trump called for one of the largest increases in defense spending in American history.

Given expectations of what the new administration might be able to accomplish, Citi says defense stocks have already run up, and are now trading at multiples the firm considers to be "aggressive."