Profit outlook for defense contractors may improve in next few months, analyst says

Key Points
  • If the Senate's $700 billion defense authorization prevails, it could lead contractors to lift their 2018 guidance.
  • Should that happen, "you could start to see upward revisions starting in January," says Buckingham Research analyst Richard Safran.
Ordnancemen gesture before loading 'dummy' missiles onto an F/A-18 Hornet on the deck of the USS George H.W. Bush aircraft carrier in the Atlantic ocean on October 25, 2017,
Andrew Caballero-Rynolds | AFP | Getty Images

Earnings guidance for defense contractors could go higher if the Senate's $700 billion defense policy bill prevails, according to an industry analyst.

A House-Senate conference committee is still working out differences over the fiscal 2018 National Defense Authorization Act, and it appears it may be close to finalizing a deal. Besides authorizing spending for everything from the F-35 fighter to warships, issues include the House bill to create a new so-called Space Corps.

Sen. John McCain, chairman of the Senate Armed Services Committee and one of the conferees, told reporters last week before the meeting he was "confident" they could complete talks within a "few days."

"Congress is very supportive of increasing defense spending, especially among Republicans, and increasing force structure [or troop strength]," said Roman Schweizer, a Washington-based defense analyst at Cowen. "But on the other hand, there's some real immediate concerns about operations and maintenance, repairing existing systems, and also refilling munitions inventories that have been expended over the last several years."

In September, the Senate passed a roughly $700 billion authorization, which includes a base budget of $640 billion for national defense programs and $60 billion for the so-called Overseas Contingency Operations war funding. The House passed a companion bill in July, authorizing $621.5 billion in defense spending plus nearly $75 billion for the overseas contingency fund.

The two bills authorize more money for national defense than President Donald Trump's budget request.

"There seems to be a general recognition here that readiness is suffering, that we have a number of programs suffering, we have a lot of obsolete equipment, etc.," said Richard Safran, a defense industry analyst at Buckingham Research in New York. "There's just tacit recognition in the House and Senate that action needs to be taken sooner rather than later."

Safran said one of the things that came out of the third-quarter results for defense contractors was "a fairly soft" guidance for next year's financial results. He said a key reason for that was the outlook for many defense companies like Lockheed Martin was based on the president's defense budget request.

The analyst said earnings outlook for defense companies may trend upward, assuming the conference committee authorizes a defense budget closer to the Senate version with much higher defense spending than the White House sought.

"There's upside to defense company guides for 2018," Safran said. "If that's the case, you could start to see upward revisions starting in January."

Yet both versions of the defense bill are higher than the sequestration cap of $549 billion in defense spending authority set into place by the 2011 Budget Control Act. To amend those limits, it will take at least 60 votes in the GOP-controlled Senate, or support from every Republican and eight Democratic senators.

"In order to get that level of increased spending, you're to need a bipartisan deal — and that has really still yet to take shape," said Schweizer.

Meantime, the Senate's version authorizes more spending on total aircraft for the Navy and Air Force than the House's bill, and both versions are above the White House's request. The House version also increases the size of the Army by authorizing an additional 10,000 troops plus thousands more to the Army National Guard and Army Reserve.

One of the aircraft beneficiaries could be the F-35 Joint Strike Fighter program. The Senate authorizes $10.76 billion for procuring 94 of the stealth fighters, or about $3.1 billion and 24 aircraft more than the administration's request.

The fleet has around 250 F-35 stealth fighter aircraft, and the Pentagon has plans to ultimately have around 2,400. Lockheed Martin is the prime contractor, and Northrop Grumman is the top subcontractor.

The Senate version also has more F/A-18 Super Hornets and P-8A Poseidon aircraft than what was requested by the administration. Both are manufactured by Boeing.

As for the Navy, the Senate authorizes more money to shipbuilding than the House bill and is above the White House's request. The Senate bill would fund 13 ships for $25 billion.

The Space Corps is not in the Senate bill, and the Air Force opposes the idea.

The Senate's version goes in a different direction on space, creating a new chief information warfare officer that falls under the secretary of Defense and gives that person responsibility for space and cyber.

"My bet would be they come up with a compromise somewhere in between and is different than those two ideas," said Todd Harrison, director of defense budget analysis at the Center for Strategic and International Studies, a Washington think tank.

Besides creating a sixth military branch, the head of the Space Corps would become a member of the Joint Chiefs of Staff. The White House rejected the Space Corps plan this summer, calling it "premature at this time" and pointing out there's an assessment underway to study possible military space organization changes while also looking at budget implications.

The lawmaker behind the Space Corps effort is Alabama Republican Rep. Mike Rogers, chairman of the House Armed Services Strategic Forces Subcommittee. In a June hearing, Rogers said the Russians and Chinese have already reorganized their own space operations, adding "the Chinese literally have a space force today."