Defense stocks: 2 factors this analyst says to consider

The US defense sector has underperformed the broader market in 2024. Is there any potential for upside? Joining Market Domination to discuss growth outlooks for the US defense sector are Bank of America Securities Senior Aerospace and Defense Analyst Ron Epstein and Citi Managing Director of Aerospace and Defense Lead Analyst Jason Gursky

According to Gursky, he advises investors to carefully weigh two factors when it comes to US defense stocks. First, "the crowding out effect" of interest rates, which could potentially impact taxes, government spending, and reform initiatives in areas like Medicaid. Secondly, "political dysfunction in DC" poses a significant risk, potentially leading to prolonged budget approval processes, threats to debt ceilings, and the imposition of budget caps.

Despite these challenges, Gursky maintains a bullish stance on the sector, expressing he expects "margin expansion to become an investor narrative".

Epstein notes that defense stocks have historically "outperformed by a wide margin" during election years, with the bulk of the upside occurring in the third quarter. While acknowledging the sector's underperformance in the first quarter of 2024, Epstein remains optimistic, stating that "the set-up into the second half of the year is actually pretty good," expressing his bullishness on the sector's forward trajectory.

For more expert insight and the latest market action, click here to watch this full episode of Market Domination.

This post was written by Angel Smith

Video transcript

The ongoing Russia Ukraine war escalating conflict between Israel and Hamas have threatened to spill over in the Middle East.

Yet against this backdrop, defense names have failed to see significant upside, the sectors underperformed the broader market this year.

But there could be opportunities ahead.

We're helping you navigate the big picture with the Yahoo Finance playbook and to discuss, we're joined by two senior analysts covering aerospace and defense.

Ronald Epstein from Bank of America Securities and Jason from City guys.

Thank you so much for being here.

It is a dense issue but one that is important to sift through when we look at these particular stocks.

Jason, I want to start with you because if you look at the US Department of Defense budget here, um you know, it's still going up into the right so to speak, it is still growing.

Why have we not seen us?

Defense stocks benefit as much?

Well, uh it's all about expectations and what the budgets are going to look like uh going forward.

And I think they look at a couple of things uh that have, you know, given some pause uh to investors here of late part of the part of that's the setup uh that you just had leading into this conversation.

You, right, the uh the potential crowding out effect of higher interest costs.

Um, you know, this, uh we, we've got choices here, right?

Is, uh, at the federal government level, we can raise taxes.

Uh, we can, uh, you know, decrease spending in, in, in other areas as interest costs become a greater percentage of the overall budget.

Um or we can reform ourselves um particularly on, you know, what's deemed to be the third rail of politics, which are the entitlement programs like Medicare, Medicaid uh and Social Security.

So that's, that's, that's one area, it's the crowding out effect.

And then the second part of it is political dysfunction and just watching what's going on in DC, uh seeing elongated periods of time in which it takes to get a budget approved, um seeing things like uh debt ceilings getting threatened, you know, going over some sort of gigantic cliff, um you know, committing suicide kind of thing.

Uh And uh and then budget caps, um you know, coming out the other side of these, these things that, that often times uh in, at least in the very near term kind of ruin sentiment uh around uh defense spending because suddenly investors are afraid that there are artificial spending caps put on, on defense spending.

So those are the two things it's um you know, uh the crowding out of interest to the cutting out of interest expense and, and fear around the political dysfunction in DC Ron.

Let let's bring you in here as well.

Maybe we just our big picture, Ron broadly.

You know, when you look at your your coverage universe, Ron us defense names.

How, how bullish are you on the sector, Ron?

In, in the kind of near to intermediate term here?

Yeah, I'm actually quite bullish on this sector.

Uh If you look at the the defense stocks during presidential election years or if you go back to 1980 anyway, and you were to look at say a basket of defense stocks, they tend to outperform during presidential election years, about 80% of the time.

And when they do, they tend to outperform by a AAA wide margin, uh almost over 1000 basis points.

And if you take out a couple of years that were just kind of massive years, it's still hundreds of basis points.

And if you peel back the onion on that uh during an election year, typically they outperform in the second half of the year and the bulk of that happens in the third quarter.

So no surprise around around election time.

So when I look at the underperformance of the sector relative to the broader market and maybe even things like commercial aerospace in the first half of the year, I think the set up into the second half of the year is, is actually pretty good.

Uh And then, and, and when you look at the, the outlays from the US Treasury, um they're a good coincident indicator for the sector.

Uh They've been up and accelerating.

Um That's good for uh good for the, the defense stocks.

So, yeah, I my, my, my stance here particularly, you know, kind of short term in the second half of the year is actually quite bullish.

Um So it sounds like both of you see some uh some scenario for upside here, Jason in terms of the stocks that you think are perhaps best poised among the largest uh airspace and defense companies.

I know you're looking at Lockheed and general dynamics.

What is differentiating those two?

Yeah, the first thing I'd say out of the gate here is II, I am on board here with, with Ron's uh thesis that the back half of the year is going to be pretty good for defense stocks because I think we are going to begin seeing uh the the backlogs that have grown here 15% over the last few years begin to make their way through the revenue streams and important, I expect margin expansion to become an investor narrative as we move into the second half of the year because these companies are starting to roll off the pre panem backlogs that they had where they had to absorb inflationary costs as well as um uh supply chain bottlenecks that led to higher costs uh for them all over the last few years.

Those contracts are rolling off, signing up new ones that better reflect the current cost environment.

So we've got accelerating revenue and accelerating margins uh as we move into 25 and beyond.

So I think that's going to be good now, as far as uh Lockheed is concerned, look, this one right now is kind of all about the F-35 um that aircraft uh is not delivering today um in light of some technical issues they're having with the software on that aircraft that should work its way out here over the next 6 to 9 months.

And I think uh investors will breathe a big sigh of relief when that happens.

I think that's an identifiable catalyst for Lockheed in the second half of this year.

And look as far as GD is concerned, chip banker, uh chip budgets are going uh have gone quite a bit higher here.

We got a lot of work ahead of us.

Uh The supply chain bottlenecks that I just talked about are getting better that will benefit GD.

And then these guys also own a bi jet manufacturer called Gulfstream that just introduced a new product.

And I think we're likely to see accelerating revenue and margins uh in their aerospace segment as well.

So, um here again, uh pretty constructive on, on both these names and Ron.

Another question I have for you, I'd be real curious to get your take on this is, you know, how venture investors, Ron have discovered defense tech start ups and, and they've moved in, we had Andres uh Palmer Lucky on the show and it's, it's impressive what he and his team, the, the portfolio they've built out, Ron in a short amount of time.

How much competitive pressure do you think these kind of smaller nimbler defense tech start ups actually pose to just kind of bigger, more established names you cover?

Yeah, I mean, they, they will potentially pose pressure one day.

Um They're not there yet.

However, um they are, you know, gaining some share.

I think a couple of really notable things, there were a couple of contracts that were just rewarded by the US Air Force recently.

Uh One was for the so called doomsday aircraft.

Boeing was up against S Sierra Sierra Nevada Corporation.

Uh It's a privately held company and Sierra beat Boeing.

Uh There's another one that was, you know, out for something called the CC A, the Collaborative Combat Aircraft that was won by uh and, and is one of the companies that, that, that won it.

And General Atomics was, Andre is one of the, the, the new kids on the block.

And General Atomics is a privately held company.

So you've seen some privately held companies in start ups gaining some share.

Now, it's just small pieces of the larger industry.

So we'll see where it all goes.

But what these, these new companies are bringing, uh, to the dod is I think a fresh approach to defense contracting.

A focus on software.

A focus on the, the interplay between software and hardware that is to say, building hardware around software as opposed to stuffing software in hardware and there.

And, you know, we'll, we'll see where it all goes.

But, um, you know, if I were at one of the big contractors today, I most certainly would be looking at, uh, you know, and all shield A I among others as, you know, you know, a potential threat down the road.

Well, and sort of on a related point.

Jason, do you think that these large defense contractors are doing enough internally to innovate to keep up with some of these, um, upstarts and, or do you think we're going to see some of the start ups being snapped up and being acquired by the public companies?

Yeah, probably more the latter, to be honest with you.

I mean, they all have, uh, you know, corporate venture capital arms.

They are, you know, looking to partner with smaller companies, uh, looking for technology plays.

Um, and, um, you know, just kind of like Cisco did back in the day or some of these tech companies done back in the day?

Right.

They, they use MN A as, uh, as their R and D budget.

So, I think this is very well, could be the way that plays out here in the defense, uh, world uh, as well.

Ron.

Quickly here.

I'm just interested to get your take on a rocket lab.

Rough start.

Ron said about 20% so far this year.

But you say it's a buy Ron.

I do.

Yeah, I mean, there was a, a whole cohort of spec funded space start ups that, uh, many of them, you know, were, how can I say, um, very, very early stage weren't, weren't quite, quite ready for prime time.

Um Rocket lab is the real deal and, and rocket lab currently is working on a new rocket called the Neutron.

Uh They are gonna, you know, test fire the engine for that uh that rocket called Archimedes in the second half of the year.

And once they test fire that that engine and that's a, you know, boom bode very well for neutron, once neutron goes into surface, which is supposed to be some say in the middle of next year, that will be a competitor to the Falcon nine.

And we've seen how successful SpaceX has been with the Falcon nine.

This will be another medium lift launch vehicle that will address that market and having there's plenty of launch.

Um There's plenty of demand for launch in that segment of the market.

So this is potentially a game changer for the company.

So yeah, when I look at what rocket lab is doing, uh they're doing some really amazing, innovative things.

Uh And uh yeah, we, we have a ban them.

And, uh, it, it's one of the smaller companies we follow that I think is quite interesting guys.

Uh, really good actionable stuff for viewers.

Appreciate it.

Ron and Jason have a good one.