How cuts in federal spending could hit defense stocks: Wells Fargo

mason01/iStock via Getty Images

The United States on Thursday is on track to reach its borrowing cap of $31.4 trillion and congressional debate about raising the limit is likely to offer hints about the direction of defense spending, according to analysts at Wells Fargo Securities.

“Any potential impact to defense spending is likely to vary by acquisition account,” Matthew Akers, analyst at Wells Fargo, said in a January 18 report. “Historically, modernization accounts which fund weapons buying tended to be more cyclical, while operation and maintenance (O&M), which funds much of government information technology work, tends to be more stable.”

A key issue will be whether Republican lawmakers who this month took control of the House of Representatives will press for a rollback in fiscal 2024 spending to 2022 levels. Such a reduction would reduce defense spending by about 10%.

“A discretionary cut of this magnitude still seems unlikely to us given that many in Congress still want spending to move higher, including for defense,” according to Wells Fargo. “However, we are taking a closer look at the potential impact if this cut does come through.”

Cutting 2024 defense spending to the 2022 level would trigger a 35% to 40% decline for defense stocks, the bank estimated. Capping it at the recently approved 2023 level could spur a 15% decline.

“The Congressional Budget Office proposed options last month for reducing the deficit through lower defense spending,” according to Wells Fargo. “Based on their report, we believe missiles, bombers and surface ships are at lower risk to funding cuts, while Air Force tankers/fighters are most vulnerable.”

Such a scenario would have minimal effect on Northrop Grumman (NYSE:NOC), according to Wells Fargo. General Dynamics (NYSE:GD) and Raytheon Technologies (NYSE:RTX), which have significant non-defense businesses, also wouldn't be significantly affected. Boeing (NYSE:BA) and General Electric (NYSE:GE) would face the greatest risks from such cuts, the bank said.

Wells Fargo lowered its price target on Northrop Grumman (NOC) to $460 a share from $575 a share, based on a lowered multiple of 19 times estimated 2024 EPS.

The key defense programs to watch this year include the contract for a next-generation helicopter, whose award last month to Bell Textron (NYSE:TXT) is being contested by rivals. A decision on the protest is due April 7.

The optionally manned fighting vehicle program to replace the M2 Bradley infantry fighting vehicle will be narrowed to three bidders to make prototypes. The contract is estimated to be valued at $45 billion.

The Department of Defense also may complete its plan to upgrade the engines for the F-35 fighter jet, which likely would be built by General Electric (GE) or Raytheon (RTX).

“We are cautious on defense despite the approximately 10% selloff since December, as we see further downside if budget growth slows meaningfully,” Wells Fargo said. “We see less risk for fed information technology, which has historically peaked later in the budget cycle.”