CHICAGO/NEW YORK --- A modest slowdown in defense spending under the new administration, due to the potential for budget cuts to help offset stimulus spending post pandemic, would not materially affect US defense contractors’ cash flows, given the prioritization of national security and the government’s goal of maintaining global leadership in defense capabilities, says Fitch Ratings.
Defense spending is up nearly 20% or nearly 4% on a CAGR-basis since 2016, with an approximately $696 billion proposal for 2021, according to the November recommendation from the US Senate Committee on Appropriations.
There is a moderate probability that another continuing resolution (CR) could go into effect in the event the US Congress does not enact a budget before the current CR expires on Dec. 11, 2020. Fitch would view a new CR as a neutral outcome for the defense sector, while President-Elect Biden develops and proposes his spending plan. Key milestones will include enacting 2021 recommended appropriations and submitting a 2022 budget proposal.
There has generally been bipartisan support for homeland security and national defense. Therefore, US defense contractors are relatively immune to changes in government leadership and modest slowdowns in spending. Acquisition spending on research, development, test and evaluation (RDT&E) and procurement, the two main defense spending areas that flow through to defense contractors, is likely to remain stable, despite budgetary pressure.
Spending on ground systems will likely stay subdued, given President-Elect Joseph Biden’s stated desire to withdraw troops from current wars. Program-specific cuts related to legacy projects are possible and international sales could decline. Restrictions on sales of drones and other military technology to Middle Eastern countries were loosened since 2016 in part to increase export revenue. If such arms sales are limited, leading to lower spending on missiles and munitions, some contractors’ international revenue would be affected.
Meanwhile, more targeted spending in technologically-advanced areas is expected. RDT&E appropriations support national security and the country’s global leadership in science and technology. Investments or the procurement of capital assets, such as technology-advanced fighter aircrafts, submarines, weapons and other military hardware are also key to maintaining technological superiority in defense.
Technology-based modernization, with a focus on cybersecurity, space, unmanned systems and artificial intelligence, will likely remain a key component of defense spending in order to stay competitive. Command, Control, Communications, Computers and Intelligence (C4I), the F-35 Joint Strike Fighter (JSF), the B-21 Raider and CVN Ford-Class Aircraft Carriers are platforms with high value emerging technologies. Long development and production cycles, high cost and importance to the national defense strategy will support funding for some of these programs. The F-35 JSF program, which Lockheed Martin (A–/Stable) is the prime contractor, is the largest program of the US Department of Defense (DoD) and will continue to be a driving force of defense investment over the next several years.
We anticipate certain prime contractors and suppliers would be more negatively affected than others to modestly lower defense spending. Tier 2 and Tier 3 suppliers would likely be most at risk, given the initiative to reduce costs by prime contractors and Tier 1 suppliers. Large contractors including General Dynamics, BAE Systems (BBB/Stable), and Oshkosh (BBB–/Stable), would likely be affected by lower spending on ground systems and legacy programs, although increased spending in other areas could help offset these declines.
Meanwhile, L3Harris Technologies (BBB/Positive), Northrop Grumman (BBB/Stable), Lockheed Martin and Raytheon Technologies will be most resilient to a potential moderation in defense spending due to high technology exposure. Each contractor is focused on technology-differentiated products vital to national security.