Donald Trump is the president-elect, and the hawks are back in the Pentagon. That's great news for the U.S. Navy -- and for three key defense contractors who build most of its ships: Lockheed Martin (NYSE: LMT), General Dynamics (NYSE: GD), and Huntington Ingalls (NYSE: HII).
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Earlier this year, a controversial plan was being floated in Congress to roughly double the size of the Navy. Currently boasting just 273 ships, not all of which are combatants, the Navy is floating about 50% below its Cold War strength of 500 ships. But efforts are already under way to get the Navy back up to something approaching full strength.
The U.S. Navy is big, but it's a big ocean, too. Might the Navy need to get bigger? Image source: YouTube still.
273, 285, 308... 355?
Two hundred seventy-three ships. The Navy's official ship count has already fallen by a dozen from the 285-ship-count of just six months ago, and it could fall farther as the Navy retires older submarines, cruisers, amphibious assault ships, and resupply vessels. To replace all the retirees, and build the fleet back up to strength, the Navy published a Force Structure Assessment (FSA) in 2014 insisting that to adequately fulfill all the missions it's being asked to undertake, the Navy needs an absolute minimum of 308 warships.
But not long after Donald Trump's election, a new number surfaced: 355.
As reported by USNI News earlier this month, the Navy's 2016 FSA has bumped up its wish list of new ships by 47 hulls. Says the Navy, this is the "minimum force structure [needed] to comply with [Pentagon] strategic guidance." In an ideal world, where money is no object, the Navy says it would like to have 653 ships, well over twice the size of the current fleet. But anything less than 355 ships will result in an unacceptable "level of warfighting risk to our equipment and personnel."
Which makes 355 the Navy's new sine qua non.
Making the list, checking it twice
What ships, precisely, does the Navy say that it needs? Here's a quick rundown showing where the current "ship battle forces" sit, where the Navy wants to go, and the number of new hulls that must be built to get there:
Who will build them?
As you can see, the greatest number of new ships on the Navy's wish list are surface combatants -- which encompasses both large surface combatants (destroyers and cruisers) and small surface combatants -- the Littoral Combat Ship, and the frigate class of warships that has evolved from it.
This is something that should appeal broadly to investors in defense companies -- because pretty much all of the major players build warships in this class. Both General Dynamics and Huntington Ingalls build large surface combatants -- primarily Arleigh Burke-class destroyers -- while General Dynamics partner Austal, and Lockheed Martin, both build littoral combat ships, and soon, "frigates.".
Similarly, investors in General Dynamics and Huntington Ingalls will like the idea of building more submarines, as both do, while Huntington will be especially pleased with the plan to add two more nuclear-powered aircraft carriers, as well as several new amphibs, to the fleet -- because Huntington builds both.
What's likely to happen
Secretary of Defense Ashton Carter reportedly rebuked Secretary of the Navy Ray Mabus for publishing the FSA, and in particular for insisting that he needs 52 frigates in the fleet. (Carter has been pushing to cut that number to 40). But now that the news is out there, it will give the new Trump administration the ammunition it needs to argue forcefully for a need to build up the fleet. Indeed, the rising size of the Navy's request will only heighten the appearance of a gap between that need and the Navy's current capabilities -- putting pressure on Congress to find the funds to fill the gap.
How much money are we talking about here? Experts estimate that growing the fleet to 350 ships or more will require at least a $4 billion boost to the Navy's current $12.3 billion shipbuilding budget -- about a 32.5% increase. Assuming maintenance and upgrades spending rises in tandem, that would be a big boost to the fortunes of Lockheed, General Dynamics, and Huntington, which, according to data from S&P Global Market Intelligence, already earn well in excess of $15 billion annually from their maritime divisions.
It would be especially good news for Huntington Ingalls, though. For one thing, although both General Dynamics and Lockheed Martin pull in good revenues from their maritime divisions, these divisions produce below-average profit margins for both companies. Indeed, Huntington Ingalls -- which only doesmaritime -- outclasses both General Dynamics and Lockheed Martin on the operating profit margins front, earning 11% profits on this business.
Meanwhile, from a revenues perspective, Huntington builds many of the ships on the Navy's wish list. Thus, it should earn better profit margins from any revenues flowing from a growing Navy, and get more absolute revenues as well. At the same time, Huntington does not build the frigates and littoral combat ships and so is insulated from any risk of that program's being cut.
Finally, at 1.2 times sales, Huntington Ingalls stock is a mite pricey right now, but it's cheaper than either of its rivals. (Lockheed Martin stock sells for 1.4 times sales, for example, and General Dynamics -- 1.7!)Between Huntington's (at least relatively) cheap stock price, and now with the prospect of a 355-ship Navy on the horizon, I think it's the single stock most likely to benefit from such a scenario.
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