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Morningstar | Boeing Is the Big Winner in Trump's $718 Billion Department of Defense Budget Request

The Department of Defense submitted its $718 billion fiscal 2020 budget request to Congress, which represents a 5% increase over fiscal 2019. However, the $247 billion in investment funding (procurement and RDT&E) is more pertinent for defense firms and is slated to only rise 2% year over year. Despite this lackluster growth, the budget is in line with our expectations and as such we're not moving fair values for the contractors we cover. Investors should take away four things: 1) Congress may increase procurement so investment growth could come in higher; 2) Boeing is a winner thanks to F-15EX, which could be worth $14 billion; 3) F-35 cuts are a concern for Lockheed but Congress may rectify this; and 4) the DoD will likely start fiscal 2020 with a continuing resolution but a budget agreement remains our base case.

Procurement funding dropped 3% versus fiscal 2019, while RDT&E increased roughly 9%. The procurement decline coupled with the RDT&E increase reflects not only DoD's gambit that Congress will plus up procurement but also the full incorporation of the National Defense Strategy, which is focused on RDT&E for nuclear weapons, hypersonics, cyber, autonomy, directed energy, space, and AI. Growing development spend may also foreshadow further pressure on margins, as contractors garner more cost-plus contracts and record fewer favorable EAC adjustments. Over the midterm, we believe the DoD may struggle with transitioning development programs to procurement.

The Trump administration is circumventing the budget control act caps by requesting $545 billion in the DoD base budget (cap compliant) and then stuffing $165 billion into OCO and $9 billion into emergency requirements. We think this approach is dead on arrival in the House of Representatives. Nonetheless, we believe another budget agreement--probably sometime in early calendar 2020 with the DoD operating under a continuing resolution--represents the most likely outcome but the process will be painful.

Procurement funding fell on the back of fewer F-35 buys and lower C-130J funding, both of which are Lockheed programs. Army ground vehicles are seeing lower procurement funding, but most of this spending decrease won't impact General Dynamics, which we cover, since the cuts are focused on the JLTV (Oshkosh) and AMPV (BAE Systems). More broadly, we think the Army's reprogramming of its budget to favor modernization over legacy programs means companies and business units with significant Army exposure like L3 Harris Technologies, General Dynamics, BAE Systems, Boeing's helicopter business, and Lockheed's Sikorsky business face a more volatile budget environment going forward. Turning to the Navy, the service added another Virginia class submarine (General Dynamics and HII), raising the quantity to three for fiscal 2020. We'd note that the Navy's planning includes savings from an aircraft carrier retirement (the USS Harry S. Truman CVN-75), something that may not get through Congress.

The Air Force is slated to account for about half of the increase in RDT&E spending for fiscal 2020 with the B-21 bomber (Northrop Grumman) driving Air Force RDT&E higher. Northrop alluded to B-21 revenue leveling off in 2019 during its full-year earnings call, so the fiscal 2020 budget increase is good news for calendar 2020. Turning to fighter aircraft, the fiscal 2020 budget request includes 78 F-35 buys, which represents 15 fewer aircraft on a year-over-year basis. Both the Navy and Air Force plan to trim their procurement quantities relative to last fiscal year. However, we think it's a distinct possibility that Congress moves to plus up F-35 procurement. On the Boeing F-15EX, the DoD is budgeting a bit more than $1 billion to purchase eight aircraft in fiscal 2020. This $1 billion includes industrial startup costs so we’d caution investors from extrapolating any unit costs off this figure. Per DoD comments, Boeing may eventually deliver 144 F-15EX fighters to the Air Force.

Finally, we’d highlight that the DoD is also planning for $7.7 billion in efficiencies for fiscal 2020. Although we haven't gotten a look at the FYDP yet, we suspect there might be an efficiency wedge included in the long-term plan that includes savings the DoD expects to materialize. This would represent a risk in our view, since achieving these efficiencies across the DoD bureaucracy can often prove challenging.