House, Senate Boost US War Funds: Stocks in Focus - Analyst Blog

Following the House Budget Committee’s approval earlier this week, the Republican-controlled Senate, in the wee hours of the morning today, approved its version of the GOP fiscal 2016 budget. The budget, while proposing to repeal the Affordable Care Act (ACA, or Obamacare) in its entirety, plans to pour more funds into the Department of Defense’s (DoD) war fighting account.

The proposed budget suggests eliminating the annual federal deficit over a decade by cutting $5.5 trillion in federal spending. There was, however, a clash within the party that led GOP leadership to put forward two competing plans. One faction − the defense hawks − wanted to funnel even more dollars to the Pentagon budget, beyond the spending caps that are part of the current sequester law, given mounting threats from the Islamic State and other terrorist groups. Another group − the deficit hawks − were determined to reduce spending.

Republicans’ Blueprint

The plan suggests spending almost $3.8 trillion in fiscal 2016 overall. The budget keeps military spending at $523 billion, the level set by the caps. It also allots about $90 billion for Pentagon’s separate war fund – the overseas contingency operations (“OCO”) fund. It is worth noting that OCO is not subject to the automatic budget caps imposed by sequestration.

Obama’s Bid

In contrast, President Obama’s fiscal 2016 budget proposal, unveiled on Feb 2, 2015, called for $3.99 trillion in spending for the fiscal year beginning Oct 1. This is a 6.4% increase from the current year budget. Of this, the Obama administration wants $534.3 billion to be allocated for the DoD’s base budget and $50.9 billion in war funds, a total of $585.3 billion. The base budget proposal is about $36 billion more than what sequestration would allow and over the FY2015 enacted budget of $496.1 billion.

Précis

Although budget resolutions do not have the force of law, it has more implications now as Republicans control both chambers of Congress. Importantly, House Republicans plan to boost the defense budget beyond $600 billion by cleverly fiddling with funds earmarked for wars in the Middle East and elsewhere.

The final budget is supposed to be passed by Apr 15.

Our Choices

Despite the contending budgets discussed above, the wind is definitely in favor of boosts to the defense budget, as the Pentagon has hitherto been mostly strained, monetarily and otherwise, with the threat to homeland security lurking. We have picked three stocks in terms of better Zacks Rank, earnings surprises and share price returns. These stocks have further upside potential if the defense hawks finally have their way.

Huntington Ingalls Industries, Inc. HII

The largest military shipbuilder in the U.S., Huntington Ingalls is the prime industrial employer in Virginia. It operates major shipyards in Louisiana, Mississippi and Virginia. The company has an expected earnings growth rate of 10.05%. Its forward price-to-earnings (P/E) of 15.37x is at a 8.8% discount to the peer group average. The share price has gained 22.98% year to date. In comparison, the S&P 500 has declined 0.13% in the corresponding timeframe.

This Zacks Ranked #1 (Strong Buy) company is, after all, more protected than other defense contractors from budget cuts as the DoD is expanding its fleet of submarines and destroyers and introducing a new version of aircraft carriers, with emphasis on the Asian-Pacific region. The company has delivered positive earnings surprises in three of the last four quarters, with an average beat of 5.28%.

Northrop Grumman Corp. NOC

With rising security threats, the defense industry’s increasing emphasis on high-tech intelligence equipment can be well traced to Northrop Grumman’s timely focus on intelligence, surveillance and reconnaissance (“ISR”) systems, advanced electronics and software development technologies. It is the proud owner of the popular Global Hawk, an unmanned system with the ability to transform itself into an operational weapons system when required. Northrop also boasts products like the E-2D Advanced Hawkeye, which provides 360-degree surveillance at all times.

This $31.61-billion-market-cap-defense Zacks Ranked #2 (Buy) company posted an average earnings surprise of 7.5% in three of the trailing four quarters. Northrop Grumman clocked an impressive share price return of 8.09% so far this year. Its forward P/E is 16.87x, a discount to the peer group average of 17.08x. The company has an expected earnings growth rate of 7.97%.

Rockwell Collins Inc. COL

Rockwell Collins is the foremost global supplier of communications and avionics equipment for both commercial and military customers. The company’s balanced exposure to both types of customers allows it to use government funding to develop products for the dual-end market. This leads to higher volume sales, which create economies of scale in cost-sensitive government contracts.

Rockwell Collins’ focus on research & development and systematic investments in inorganic growth programs will likely be a boon for its future performance.

The company’s shares gained 11.91% so far this year. It currently carries a Zacks Rank #2 and has a solid earnings surprise trajectory beating the Zacks Consensus Estimate in three of the last four quarters.

Its forward P/E multiple stands at 17.87 while the expected earnings growth rate is 11.81%.

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