The Pentagon's annual budget request is a shopping list featuring some of the most sophisticated, cutting-edge technologies available on the planet. But one item that stood out in this year's request was the military's embrace of a 1960s-era fighter jet that the Air Force said it intends to acquire in significant quantities in the years to come.
The Air Force has proposed buying up to 80 Boeing (NYSE: BA) F-15 fighters at a total cost of nearly $8 billion over the next five years. The F-15 was developed by eventual Boeing acquisition target McDonnell Douglas in the late 1960s but has not been purchased by the U.S. military for nearly 20 years.
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To be clear, this is not just 1960s technology. Through the years, Boeing has continued to modernize the design; in 2015, it unveiled upgraded electronics and other improvements that the company says should keep the fighter relevant through 2040. But given the Pentagon's many options, the F-15 request is a surprise, especially since the Air Force also wants to keep the pace of buying the newer and more advanced Lockheed Martin (NYSE: LMT) F-35 flat.
There's a lot of palace intrigue surrounding the decision, and it's difficult to predict whether this request will eventually be funded by Congress. But some of the commentary about the decision by military officials provides valuable insight into the way the Pentagon operates, and it helps lay out the bull case for investing in defense stocks.
Finding the right tool for the job
At face value, the F-15 decision came down to the Pentagon wanting to squeeze as much military might as possible from limited funding. The Pentagon's explanation, as contained in its budget acquisition summary, is that the F-35 and the smaller F-22 Raptor are too valuable and too expensive to operate against certain lesser threats.
The purchase, according to the Pentagon report, "reflects the Department's strategy to layer capability to address different threat situations." The government is buying F-35s "to address advance technology aircraft being deployed by Russia and China," the report says. But to defeat lower-technology platforms, it wants to use older designs "which nominally have lower operating costs when compared to 5th generation combat jets such as the F-22 and the F-35."
But if affordability is a key concern, an older Lockheed Martin model, the F-16, would seem to be a more logical choice. The F-16, introduced around the same time as the F-15, usually carries a cheaper per-plane cost. And because it is a single-engine model, it is less expensive to operate.
Critics of the F-15 push, including the watchdog group Citizens for Responsibility and Ethics in Washington, have suggested the surprise request was influenced by Acting Defense Secretary Patrick Shanahan, who before joining the Pentagon worked at Boeing for 30 years.
The Pentagon has vigorously denied those allegations, saying Shanahan is not a part of any procurement discussions involving Boeing. But the accusations have led military leaders to open up about the F-15 decision, and their comments should be of great interest to defense investors.
It's all about the base
The choice to go with the F-15 was strongly influenced by the Pentagon's desire to make sure at least two American companies continue to make fighter jets into the next decade, according to an unnamed senior Pentagon official who held a briefing with reporters last week.
Lockheed Martin has won every major fighter competition held over the last two decades and is the lead contractor on both the F-35 and the F-22. It's not clear when there will be a new competition because the F-35 program is relatively young, and the government is not ready to commit to its replacement; plus, progress is being made with autonomous planes that could one day work with fighters. So the Pentagon is worried that when the time comes for another competition for a defense contract, Lockheed could be the only domestic candidate.
The deliberation over the F-15 "turned into a conversation of, for the future of the Department of Defense, it's going to be good to have multiple providers in the tactical aircraft portfolio, and that's what led our way into the F-15X decision," the senior official reportedly said.
Concerns about the industrial base are not just limited to fighter jets. The Navy, for example, has seen 14 defense-related new-construction shipyards close over the past 60 years, leaving the service reliant on just seven yards owned by four contractors. For some programs, like aircraft carriers, there is only one contractor, and for most major warships, the Navy must deal with a duopoly of Huntington Ingalls (NYSE: HII) and General Dynamics (NYSE: GD). The service has identified preserving and building that industrial base as a priority and has suggested it will be a factor in future ship-buying decisions.
Invest with confidence
The good news for defense investors is that the Pentagon, in justifying the F-15 decision, has all but declared that it is department policy to backstop major defense contractors. There are risks to owning any stock, but if a contractor can avoid fraud and manufacture a competent product, the primary customer is willing to make sure there's at least enough incoming business to keep the operation strong.
The bad news: In a world where everyone is a winner, it is harder to pinpoint the true outperformers. I favor Lockheed Martin based on the broad strength of its diverse portfolio, and General Dynamics on the hope that an underperforming commercial unit will soon soar again. But these stocks tend to ebb and flow relative to each other based on recent wins and what programs the Pentagon is emphasizing at the moment.
It's still too soon to say how many, if any, F-15s the Air Force will eventually buy. Regardless of what Congress authorizes, a small shift in Pentagon spending on its own is no reason to buy Boeing or sell Lockheed Martin. But long-term holders of these companies and their peers should rest easy knowing that the government is committed to making sure none of them will run short of business anytime soon.
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