What a Chinese Missile and the Midterm Elections Mean for Defense Stocks

Starry sky 2 sounds peaceful enough, and when China’s top aerospace scientists announced in August that they had successfully tested a device of that name, they described it as an aircraft. But the details of this flight—sustained speeds between five and six times that of sound, combined with abrupt changes in direction—delivered an unmistakable message to Pentagon analysts. China is close, perhaps just several years away, to fielding a fearsome new weapon called a hypersonic missile. That could make today’s missile defense systems obsolete, drive a new arms race, and keep money pouring in for military contractors.

Understanding the hypersonic threat, and America’s rising rivalry with China more broadly, is one way for investors to make sense of the outlook for defense stocks. After six years of outperformance, they’re slumping. With U.S. budget deficits ballooning, and Democrats predicted to win control of the House on Election Day, investors seem to anticipate that a two-year surge in defense funding under President Donald Trump will give way to a slowdown. From the Reagan peak to the Clinton low, a 13-year stretch, the defense budget shrank by 35%, adjusted for inflation. During President Barack Obama’s tenure, it declined by 30% over five years. In a budget crunch, it’s easier to find cuts in weapons procurement than in categories like personnel and maintenance, adding to volatility for weapons makers.

In reality, the chances of deep cuts from here look overstated. Already agreed-upon spending will increase revenue briskly enough for the likes of
Lockheed Martin

(ticker: LMT), Northrop Grumman (NOC), and

(RTN) through the end of the decade. Beyond that, it seems likely that budgets will remain flat, perhaps rising with inflation, during what some industry analysts describe as a shift from a war-on-terror footing to Cold War 2.0, with rising investment in futuristic weapons offsetting declines in legacy programs. Longer-term headwinds include fiscal strain and a potential deflationary effect from new technology, including software.

Climbing Back

Military spending is on the upswing after inflation-adjusted declines during the Obama administration. Defense budget in 2019 dollars, 1950-2019

For now, however, the selling in defense shares appears overdone. Lockheed stock is down 7% this year, not counting dividends, versus a gain of 2.5% for the S&P 500 index. Earnings are soaring. Wall Street predicts a 32% rise this year, to about $17.50 a share. That puts the stock, recently around $300, at 17 times earnings, on par with the S&P 500, and down from 24 times earnings a year ago. By 2020, Lockheed’s profits are expected to hit about $24.50. The stock trades at just 12 times that figure, with a 2.9% dividend yield. All of this points to potential for double-digit annual returns over the next few years, no matter how the midterm elections shake out. The outlook is similar for other defense heavyweights.

Hypersonic missiles provide a useful example of why budgets look secure in the near future, but also why they could come under pressure over the long term. Broadly defined as maneuverable missiles that can travel at five times the speed of sound or faster, they combine the strengths of cruise and ballistic missiles with the weaknesses of neither, and add capabilities all of their own.

Cruise missiles can be guided during flight and delivered to precise targets, but typically fly close to, but not over, the speed of sound, or Mach 1, which is about 770 miles an hour. A typical Tomahawk missile, for example, flies at 550 mph. Last year, the U.S. launched 59 Tomahawks targeting a Syrian airfield in response to a chemical attack on civilians by that country’s government. Ballistic missiles can fly much faster, but mainly follow a gravity-defined path, like a baseball thrown from center field to home. These include intercontinental ballistic missiles, or ICBMs, which exit and re-enter the atmosphere. Among them: the Trident II, which can deliver nuclear warheads anywhere on Earth from U.S. submarines, and can reach a terminal velocity of Mach 24.

Hypersonics promise ballistic-like speed with cruise-like maneuverability, plus the ability to fly at low altitudes. The result is a weapon that can penetrate any of today’s missile defense systems, and keep its target unknown until minutes before impact. Like other missiles, hypersonics can theoretically be equipped with a variety of warheads, but they can also do profound damage with no warheads at all, due to their high kinetic energy. A 500-kilogram projectile that hits a target at Mach 8 delivers the destructive power of three metric tons of TNT. Put differently, a hunk of metal moving that fast can be as deadly as six Tomahawks. That raises the possibility that these weapons can one day be deployed cheaply to counter the world’s most expensive military assets. “Imagine a $500,000 Chinese missile that can neutralize a $20 billion U.S. carrier group,” says James Cross, a portfolio manager at Franklin Templeton Investments, who specializes in aerospace and defense.

Research on hypersonic flight is decades old, but the subject is suddenly front-of-mind in defense circles. In March, Russian leader Vladimir Putin touted “invincible” hypersonic missiles, and in July, days after he and Trump held a meeting, the Kremlin’s ministry of defense released videos of hypersonic tests. U.S. officials are well aware of the threat from China and Russia. “I’m sorry for everybody out there who champion some other high priority,” said Michael Griffin at a March conference, shortly after he was confirmed by the Senate as undersecretary of defense for research and engineering. “But there has to be a first, and hypersonics is my first.”

Hypersonics don’t change the threat of mutually assured destruction in the event of an all-out nuclear exchange between superpowers. But they could make smaller-scale or regional conflicts riskier by sharply reducing decision-making time in the event of an attack, and encouraging adversaries to strike first. In a report last year, Rand Corp. urged a hypersonics nonproliferation treaty among the U.S., Russia, and China, warning of “hair-trigger states of readiness.” If a pact is in the works, it isn’t obvious from Trump’s recent announcement that the U.S. will withdraw from an arms-control treaty with Russia that dates back to the Cold War, or from battling China over trade.

Former Symantec chief Mike Brown.

Former Symantec chief Mike Brown.

Photograph by David Paul Morris/Bloomberg

In September, JPMorgan defense analyst Seth Seifman estimated that U.S. spending on hypersonics will multiply four times, to $1.5 billion, in the current fiscal year, and exceed $5 billion a year—perhaps much more—in the next decade. “Historically, technologies like this can lead to action and reaction, and maybe an arms race,” says Richard Aboulafia, an analyst with defense researcher Teal Group. “Russia has more intellectual property, but China has more resources. And China has more reason to change the game.”

In the context of a $700 billion U.S. defense budget, hypersonics alone won’t move the needle greatly for defense contractors, even Lockheed, an early winner of development contracts. But hypersonics are one example of what industry experts describe as a shift from counterterrorism as an investment priority to competitiveness with near-peer nations. Adjusted for local purchasing power, China’s total military spending now probably comes close to that of the U.S., according to
Credit Suisse

analyst Robert Spingarn. One source of ongoing tension is China’s interest in projecting strength in its nearby waters, including the 110-mile-wide Taiwan Strait, which separates the mainland from Taiwan, which China considers a breakaway province. In October, the U.S. sailed two warships through the strait in a show of force.

Beyond hypersonics, the Department of Defense is eager to keep up with China in emerging fields, such as artificial intelligence and the ability to deploy vast swarms of unmanned drones. Defense companies are having to learn from Silicon Valley about how to innovate and take risks with their research, says Franklin’s Cross. And there’s a rising role for America’s tech titans. “In China, the biggest tech companies have already been recruited by the government and have been given assigned portfolios like A.I., bioengineering, and autonomous vehicles,” says Cross. In the U.S., the Department of Defense announced that former Symantec CEO Michael Brown will head a new innovation unit in Silicon Valley, which will try, among other things, to persuade tech outfits to work with the military.

Technically, the U.S. defense budget remains subject to steep cuts triggered in 2013 and running through 2021—the so-called sequester. But Congress has passed three budget agreements to help neutralize the sequester, the latest covering the budget through the current fiscal year ending in September 2019. A $717 billion defense authorization act signed by Trump in August paves the way for one of the largest funding increases in recent decades. Much of the spending will go toward weapons procurement after a yearslong lull. Top programs include F-35 Lightning II jet fighters from Lockheed; Virginia-class submarines, Ford-class aircraft carriers, and Aegis destroyers from
General Dynamics

(GD) and
Huntington Ingalls

(HII); and KC-46A tanker planes from


Imagine a $500,000 Chinese missile that can neutralize a $20 billion U.S. carrier group.

—James Cross, a portfolio manager at Franklin Templeton Investments

The plan for next year’s funding was recently thrown into uncertainty. The Pentagon has been preparing a $733 billion budget. On Oct. 26, Deputy Secretary of Defense Patrick Shanahan announced at a conference that he had been asked by the White House’s budget director to come up with a $700 billion plan instead. Shanahan mentioned hypersonics research as a target for cuts, and said he would proceed for now with preparing two budgets. “It comes down to a judgment call of how fast we modernize,” he said.

One reading of this is that, to spur a compromise, the Pentagon is floating the prospect of program cuts that would be unpopular in Congress. Adding to the uncertainty is the need for one more budget deal to head off what is left of the sequester. Another wild card: It has become common over the past two decades to top off base budgets with supplemental funding for “overseas contingency operations,” and to use these to pay for long-term operations, not just unanticipated events.

Byron Callan, managing director of Capital Alpha Partners, which supplies defense research to investors, sees a 1% base budget increase next year. Credit Suisse’s Spingarn notes that fiscal 2018 and 2019 spending was driven by a push to replenish the military. He predicts that this focus will dissipate, but be replaced by an emphasis on China, with the likely result being a tailwind for defense companies, but not a big rise in outlays beyond current levels.

If that’s the case, shares of defense contractors could have another leg up after next year’s budget is resolved. Over the past decade, Lockheed has traded at an average of 15 times near-term earnings projections, so if the 2020 consensus holds, that implied price of 12 times earnings is likely to look low to investors. Likewise, Raytheon and Northrop fetch 13 times projected 2020 profits. Raytheon’s focus on missiles, like Lockheed’s expertise in flight, makes it a likely key player in hypersonics. The same goes for Northrop, which completed an acquisition of Orbital ATK in June, gaining new exposure to rocket propulsion systems. Mergers and acquisitions could increase, as large research-and-development budgets become more important in vying for futuristic weapons contracts. In October, military communications specialists
L3 Technologies

(LLL) and

(HRS) agreed to combine. Raytheon and Lockheed collect about 30% of their revenue from exports, which provides insulation from U.S. budget cuts, but carries other risks. Graphic images out of Yemen, where a U.S.-backed Saudi coalition’s war against Houthi rebels has put 14 million civilians at risk of starvation, could prompt a backlash from Congress.

Long term, the clearest risk for defense companies is that the U.S., following hefty tax cuts, returns to trillion-dollar yearly deficits. Debt held by the public, recently 78% of gross domestic product, is expected to hit 96% within a decade. Defense is about half of discretionary spending, so fiscal hawks seeking cuts outside of entitlement programs are likely to look there. Over time, it’s also possible that new technology will replace pricier legacy systems. “If you can get hypersonics down to $2 million a copy, that could cut into spending on conventional weapons and air-defense systems,” says Capital Alpha’s Callan. Artificial intelligence could be even more disruptive, letting swarms of cheap drones overcome pricier battlefield assets. “Pilots cost $1 million to train and need housing, but not A.I.,” says Callan.

For now, however, the recent shakeout among defense stocks seems extreme, and election risk, overstated. “Historically, a mixed Congress has been good for defense,” says Teal’s Aboulafia. “A Republican at the top and a Democratic Congress has been really good.” 

Write to Jack Hough at jack.hough@barrons.com

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