Happy New Year? Aerospace/Defense Earnings and Policy Preview

GAUTAM KHANNA: Big picture, these companies, the big primes, do approximately 225, 250 billion of US defense sales annually. They are the military industrial complex. And so I just want to be clear, it's very hard to displace that which is the supply chain.
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ROMAN SCHWEIZER: From DOD to Congress, and from the White House to Wall Street, the Nat Sec Need to Know Podcast, an unrehearsed podcast presenting insightful discussion and forecasts of the major national security and defense issues of the day. Welcome to the Nat Sec Need to Know. Thank you for joining me, and I've got a special guest, my colleague Gautam Khanna, who is our aerospace and defense equity analyst.
We're going to take 30 or so minutes to discuss the top issues that we see headed into the first quarter of this year into the earnings season. And after a busy start to the year with some geopolitical and budget events, corporate events all going on all at once, please join us as we get into some of our key issues in the month ahead. Let's get after it. Hi, thanks for joining us and Happy New Year. This is the first Nat Sec Need to Know Podcast of January.
We're sort of doing a special one. This is going to be my colleague, Gautam Khanna, and I just talking about big issues over the course of the year where we're at in terms of the upcoming quarterly earnings season. Also, the fast-moving chain of events we've seen in DC. And then we also just kind of wanted to do a brief recap of a pretty large ahead of the curve that we published as a collaborative report back on December 12th that some folks may have missed into the holiday season, but we kind of wanted to lay it out because thematically, it's right in line where things have been going.
And so we think it's got a pretty good shelf life, and we're going to probably refer to it over the course of the year as we see some additional milestones. From my perspective, we've got 26 appropriations. We've got word of a new $1.5 trillion defense budget, second reconciliation bill, as well as outlays and things headed in the quarter. But before I get into that, I'm going to pass it to my colleague Gautam so he can go through where he sees the quarter headed for primes and government services. We'll go from there.
So Gautam, passing it over to you. Happy New year, bud. And let's get after it this year.
GAUTAM KHANNA: Hey, thanks, Roman. Happy New Year to you, as well. On the Q4 aerospace and defense preview, we basically were arguing not to fight the improving defense sector sentiment. Obviously, we've heard some inklings of a $1.5 trillion ask at some point for 27, a big increase from the sub-1 trillion in '26. We've seen a change in geopolitics over the last couple of weeks with some of the more aggressive US posture towards South America and Greenland, among others.
And it's an election year, so defense spending tends to be a positive for US jobs and votes for incumbent congressmen. So I think this does bode favorably for at least a big increase in the Department of War's budget. Even if it's not the full $1.5 trillion, eventually, all defense stocks will benefit from those trends. Lockheed may see the biggest sentiment swing, given it's the largest, most liquid name in the group and is coming off a pretty subdued level of investor sentiment following a year of charges and some fighter aircraft program losses.
Switching over on aerospace, it's more of the same. We're expecting kind of bullish price demand and supply chain rhetoric out of the companies. Formal 2026 guides across the group may underwhelm, with the exception perhaps of Boeing. Guys like GE, Howmet, Hexcel, even ATI, RTX, likely are going to guide at or below consensus, i.e. Conservatively, as is their custom. And so you have to wait for them to actually do better before the stocks kind of work.
The one exception I mentioned could be Boeing and perhaps GE, because GE will beat Q4 by enough where if they guide a year-over-year increase of only a billion of EBIT. You get to where consensus is already. Boeing had already previewed they might guide to low single digit free cash flow in 2026. We expect them to do that, but perhaps amplify that comment with some context of that which is non-recurring and suppressing cash flow in 2026, which will give people a view of a cleaner baseline as they move into '27 and '28. I think that's exciting because it's an under-owned stock, but I'll leave it there.
ROMAN SCHWEIZER: Great. Thanks for that, Gautam. And so from my perspective, I just want to go through some of the big policy nuggets and things that we've seen. One, fiscal '26, continuing resolution will expire on January 30th. Congress is actually chopping wood, and passing bills and doing their job. It looks like the Senate will clear a two-bill package, and we are getting to the finish line on appropriations. By the time you are listening to this, it is expected Congress will have released the compromised version of the defense appropriations bill for '26, continuing a pretty solid stretch of ruining my weekends this year.
So myself and, of course, my fantastic associate Liz will have cranked through that to, hopefully, give some read-through's. It's expected that will be up probably $8 billion in line with the National Defense Authorization Act, which has already become law. There's an opportunity there that there could be some additional money even beyond the 8 billion. But look. Coming on top of $150 billion for defense to get even more money I think just tracks back to Gautam's view that there is a pretty robust environment for defense right now.
One thing, as most folks will know by the time of this, outlays for the quarter look pretty solid. We track both investment at FMS. Investment was up 6% for the quarter, and then FMS was up 16%. So again, there has been robust FMS. That's been part of the story. O&M was very soft, though, down 12%. So that certainly, probably bodes poorly. Unclear why that is. That could actually still perhaps be some shutdown-related, but probably more the year-over-year comps from Ukraine because there was no Ukraine spending a year ago. Maybe those comps rolling over again. We'll have to see how that pans out for the O&M-sensitive companies.
All right. So the two big pieces of news over the last several weeks. One is the $1.5 trillion budget. I'll just point out a couple of things on that. The State of the Union is expected to be February 24th. We would hopefully see at least some sort of skinny budget with just the top lines out of OMB, like last year, and probably factoring in a $1.5 trillion request. We've had a slew of inbounds about what the final number is going to be or how this plays out. I can't say 1.5 is going to be the final answer. That would be 4.8% of GDP. That is the magical number.
4% to 5% GDP for defense is the range-- is where the world's at right now. I am reasonably confident that the budget request will be at 1.5, and then we will go through the process of how to get that. So as I've been saying for months, it's always dangerous to spike the football. But the Republican Study Committee did release its broad outlines of the second reconciliation bill. There was no defense money in that. Don't panic. Senator Lindsey Graham has not been activated yet.
He is actively monitoring the situation to use the current meme, I guess. The defense money will certainly hitch a ride on that. But keep in mind, this second reconciliation bill, which I have long said the Republicans would be foolish to not attempt, is simply going to be all about getting them reelected in November. This is their chance to do big things before they lose the House, potentially, but it is also their opportunity to do long-standing things that are hard to peel back.
So there are some things in there about housing, about health care and other things, and perhaps a generational boost in defense spending, which, again, is just going to be a one-timer that we view as amortized over four years. If they go for July 4th, July 4th is the 250th birthday of America. It would be pretty splashy of them to do that $1.5 trillion for America's birthday. The other thing I need to remind folks, the defense discretionary budget is still going to be around 850.
So everyone is talking about this as a $500 billion increase, but let's not forget about the $150 billion that was added to this year's budget to get there. So we view that '27 budget as something around 850 billion in discretionary, and then 650 billion in mandatory spending, which is crazy. So that's obviously more than a 50% increase. So just pay attention to that, I think, as we go through the next couple of weeks. And then the reconciliation bill, of course, moves on a separate track from the regular appropriation cycle.
So I'm going to pause on all of that stuff, and I just want to flip ahead of the curve that we published in December. The reason we did this was really to figure out, do some deep thinking on where the Trump administration was heading, what its spending priorities were, what we saw as a result of reconciliation, and really, the direction-- the long-term direction that the department was going as a function of that. And we wanted to think about durability of that spending, because golden dome is probably not going to get funded by Democrats in Congress, so there is certainly some risk there.
That's one reason why you might want to do a big reconciliation bill is get money for golden dome and golden fleet, because the Democrats aren't going to do it in the next couple of years. We identified six areas, and we tranched them into three different buckets. And we also wanted to address the area of the traditional defense industry, as well as the new entrants or what we've kind of coined the term military tech fusion companies. I'm going to briefly cover this, and then I'm going to turn it over to Gautam for his view on how he sees the industry evolving, as well as company impact of how we see spending going over the next 10 years.
So we kind of bucketed up front, when you think about long term spending needs or fundamental changes in the budget, strategic nuclear forces and unmanned systems. The modernization of strategic nuclear forces, the nuclear triad, the programs that go with it, as well as, really, the "genie out of the bottle," "toothpase out of the tube" moment on unmanned systems. And so I think we've seen that in both cases, and these are really two areas that 10 years from now, the spending is going to continue to be significant. And this is the domain of both primes and non traditionals.
Then we move down into space and shipbuilding. Again, I think it's a question of the funding has already been significantly increased in those areas. But funding will still be in demand. And then we get to missile defense and munitions. Again, robust spending headed into those categories. But the question is really, would a Democratic president or Congress fund golden dome as envisioned? And how long is the munitions cycle? Is it five years? Is it seven years? Is it 10 years? Whereas some of the other categories, we see strategic nuclear forces, unmanned systems.
These are decades-long investment cycles. That's really just the summary I wanted to give. I'll toss it over to Gautam for his take on how it's evolving within the companies.
GAUTAM KHANNA: Thank you, Roman. Just to reflect on what we articulated in that report with Roman, in the long historical context, the initiative by the DOW to actually move forward with some of this military tech fusion is not new. And I think sometimes the street perceives the incumbent defense contractors as stodgy and not ahead of the curve. Now, there are attributes of them that would fit that bill, but then there are very long-standing technologies, supply chains and product categories where they're dominant and actually leading in technology.
So I just want to make the point, when we think about leaders in unmanned, Northrop Grumman comes to mind. Parts of Textron come to mind. Lockheed Martin is advancing some unmanned helicopter programs, et cetera, et cetera. So I think sometimes the rhetoric coming out of the administration and out of the investment community is that the primes are very vulnerable. On the margin, they are vulnerable and will have to adapt.
But I just want to be clear that, in many cases, they're leaders in a lot of these emerging technologies and have supply chains and mature products that work already. So they have an incumbency advantage that's formidable. That was the first point we made.
The second is, we're already seeing the large cap defense names partner with a lot of these emerging companies. We explained that in great detail in the note. I'm not going to regurgitate that here. But the point is they are being proactive or reactive. Whatever it is, they're getting involved.
So they're feeling the pressure and they're responding. And so again, when we rarely but occasionally get the question as to whether any of these companies are going to be irrelevant in 10 years, or out of the business in 10 years, the answer is, very unlikely that that would actually be the case, because they are partnering with some of the leading candidates that are driving some of this technology adoption.
Lastly, I just wanted to say, to Roman's point, shipbuilding is a priority, and there are very few ways to actually do it with the industrial base in the United States. So we've been pitching HII, and to a lesser extent, General Dynamics on this thesis that they are the games in town, and there is urgency to field a lot of these weapon systems in shipbuilding, or whether it be missile defense, or what have you, soon. And therefore, the only way to do so is via the incumbent companies that have the capacity in place now. That leads to better demand that we'll see coming out of HII, out of the US Navy.
We'll see orders. We'll see 15 submarines put on contracts shortly, five Columbia class, the next block of Virginia class subs. We will see on the margin opportunities to bolster the supply chain by the Department of War. So we're hearing a lot about Korean shipbuilders coming in to perhaps make sub assemblies that will improve the throughput of the primes at the shipyards, et cetera, et cetera. I view these more as opportunities and less as threats, I guess, I would say for the incumbent defense companies.
Big picture, these companies, the big primes do approximately 225, 250 billion of US defense sales annually. They are the military industrial complex. And so I just want to be clear, it's very hard to displace that which is the supply chain. One question we've been getting a lot in the last week is, you may have seen L3Harris announce kind of an unusual structure for their missile products business, formerly called AJRD where they're going to spin off part of it, take a government investment and new public shareholder investment to fund a big uptick in cap ex.
That will create effectively a tracking stock, where they will retain about a 70% to 80% ownership interest in the missile product business. Now, that was an unusual structure. I've been asked many times if this will form a precedent for other defense large caps doing something similar. I don't have a great answer to that. This kind of came out of nowhere.
But one thing that was unusual about this specific instance was, it looks like the Department of War has basically asked AJRD to spend an additional $1.8 billion in cap ex over the next four years, relative to what LHX was expecting to spend on its own for AJRD. Now, LHX never gave those numbers, but you can discern it from some of the disclosures that they were expecting to spend somewhere in the order of 1.2 billion for AJRD's cap ex through 2029. And on the announcement that came out earlier this week, it looks like that number is now $3 billion.
Hard to see other product categories that need such an extreme investment so quickly. We've seen precedent, and I'd love Roman's perspective on it with, Lockheed and the Pac 3 agreement they came to, which was kind of unusual. But there it was a cash-flow-neutral contract, or at least framework for an eventual contract. The case of AJRD's missile products seems kind of like a one off.
So I don't know that we will see similar things, but it does beg the question that if the missile products business trades at a very high multiple in the public domain, do some of the large cap defense names look to perhaps spin some of their segments that may get a similar multiple? No idea if that's going to happen, but that is the basis for a lot of investor discussions we've been having over the last couple of days.
ROMAN SCHWEIZER: I want to riff off that, and I'm going to make a larger sort of conclusion, as well. But the partnering between the primes and military tech fusion companies, that goes both ways. Because as much as the-- and not to call out any CEOs, but there's a lot of bashing from the newer companies of the primes, but they sure do want to partner with them in a lot of different areas. And if that company has 100% market share or significant market share in a certain area, the best way to get in that business is to partner with them, and whether that's existing programs, or new work, or whatever.
So I think there's going to be more of a symbiotic relationship than people fully appreciate, because the primes are using the defense tech companies to be responsive to the current leadership in DOD. The defense tech world, or military tech fusion companies want access to the primes market share and programs and collaboration. So this is a two-way street.
I was just this morning reading that Lockheed Martin has made a $50 million investment into Saildrone. And Northrop is partnered with Firefly on its new rocket that is going to be tested this year. And Northrop, as well, is going to be the lead on the Kratos Valkyrie offering or Marine Corps CCA program. So again, there is a lot of cross-pollination. I wouldn't call them joint ventures, maybe teaming and things like that.
Now, the one thing I do want to just mention, there is something going on here with munitions. We published it in Ahead of the Curve. Deputy Secretary of War Steve Feinberg has something called the Munitions Acceleration Council. I will tell you, in recent conferences-- and Liz and I were at Surface Navy this week-- everyone is talking about how DOW is on a war footing, sense of urgency. I've talked about it.
I more flippantly say, DOW is getting ready for war with China. But Sec War Hegseth talked about it at the Reagan forum, that it's about deterrence. So you need to have those munitions, and ships and aircraft to deter China, which I think is valid, the peace through strength mantra. Let me just track that back, because I realized I missed one big thing that I think Gautam and I have both had a ton of inbounds about the buyback EO. And so I'm going to walk this through into a larger thing.
My understanding is Dep Sec War Feinberg has been trying to negotiate multiyear contracts with Lockheed and RTX since maybe March of last year and has not been able to get to yes on that, or had not been able to get to yes on that. And the munitions ramp basically tripling, 12 different kinds of munitions that are vital for war with China or deterring China, and they have not been able to get that. It's the demand signal. It's the guarantees. It's the ROI. It's all of those things.
And then you had President Trump's comments at Mar-a-Lago before Christmas about the potential buyback EO. I think, I don't know, but I would suspect there were some pretty active negotiations or talks. And you had three things happen. You had Lockheed get to yes on a seven-year Pac 3 MSE concept, not a contract. Still needs to be approved by Congress, and that could be always sync things. You had RTX apparently do nothing or somehow draw the ire of President Trump, or Dep Sec War Feinberg, and get mean tweeted. And I suspect there's a lot going on behind the scenes on that.
And then a week later, you had LHX get to the deal regarding missile systems. And again, solid rocket motors are the linchpin in this. And so I'm sure DOW is thinking heavily about that. So I'm curious. The one other company that's out there is Northrop. How do they have to respond to this? They are a SRM maker, as well as perhaps a missile prime aspirant. So again, it is a "all hands on deck" moment on missiles.
And then the one thing that I would say, Gautam I would throw it back to you just for musing. But there is one other industry, I think, that is ripe for investment, both government and private, where demand is great and capacity is not great, or execution. And that's simply shipbuilding. We get the sense that there's going to be a lot of money poured into shipbuilding. But I suspect the shipbuilders and this upcoming 15-boat-- this 15-submarine contract is probably $90 billion worth of submarines.
I'm sure the companies are probably being asked to put some skin in the game, and I wouldn't be surprised if that might be the first place where we see this buyback executive order potentially thrown into the mix, as well. So Gautam, I just pass it back to you for your thoughts on that.
GAUTAM KHANNA: Yeah, it's a very good point, Roman. You are correct. Shipbuilding is capacity-constrained, the demand is tremendous and the visibility is also tremendous. It goes out many years. And we also have to be mindful. Companies like HII just won back, or won for the first time, the frigate program from Fincantieri. So that was a bit of a feather in their cap. And also, there's talk about the golden fleet destroyer potentially coming to both General Dynamics and to HII who make destroyers in concert with one another.
So there's certainly a carrot that has been offered. The interesting thing I've found, anyway, was, when you look back at HII, they've taken up cap ex dramatically as a percentage of sales over the last couple of years. And one of the things they seem to have negotiated into their contracts already, going back a couple of years, is offsets to that cap ex via advances. And so we haven't seen free cash flow as cash flow from ops-less cap ex collapse, despite the increase in capital expenditures at the company on a relative to sales.
And so what's been interesting there is, I feel like we've already seen some precedent from the Department of War on how they approach industry with making it less onerous of a cash burden to expand capacity. So maybe that kind of rubric persists. Maybe it scales to your point. What you've been atop of and written volumes on is, like you mentioned, the Korean yards somehow participating in the US shipbuilding industry.
And so far, it appears to be less as a direct threat, a direct competitor, but more as a potential manufacturer of subcontract assemblies, if you will, to increase the throughput below that of the prime integrator level, so the subcontracting level. I suspect we'll see more of that in the near term, and we'll see more of the type of contracts where these guys are made cash-neutral, if you will, for taking up capacity, especially at places like Newport News or Electric Boat, where the capacity constraints are more acute.
On the Ingalls and Bath, if you will, the destroyer yards, capacity is less of a constraint. In terms of physical capacity, yes, there's a labor force challenge that everyone's working through, but the physical capacity exists. So it's less of an acute problem than it is at the nuclear yards, for what it's worth.
ROMAN SCHWEIZER: Just to piggyback on that, a couple of things. One, from what I understand, Virginia production rates are still at around 1.1 a year. Two is the magic number, and the Navy's buying them at two per year. So as the CNO of the Navy has said, Virginia production rates need to double just to get to 2, essentially, 1.1 to 2. And again, I understand, the Virginia-- those new block fives are bigger with the payload module. And then you're just going to be inundated with Columbia work.
So one, that is on that. Second thing, we were at Surface Navy this week. And Gautam, I'm going to correct you in the good natured way possible that, remember, these are battleships, not destroyers, or what the president and senior Navy leadership are calling battleships. But they are 35,000-ton-- estimated or expected to be 35,000 tons, so 2 and 1/2 to 3 times, really probably 3 times the size of a DDG. Plus, at the same time, you're doing DDG, because I think the plan is to do everything, the battleships, and keep building DDGs, and build frigates, or FFs, no longer FFGs, because these will not have VLS in them. That's a whole separate sidebar.
But the Navy is considering building 50-- the range that we saw public display-- public disclosed, rather, 50 to 65. 50 to 65 frigates. And I think the expectation the first one will be put on a contract at Huntington sometime this year, but they will be built or they expected to be built nationwide. So there certainly will be other shipyards likely in the mix on that. They could be Koreans. They could be different shipyards, et cetera, but we'll have to see how that plays out in the upcoming budget. I think, hopefully, we'll get that budget perhaps in the late February or early March time frame.
And then the last thing I would say is, I think there is a palpable sense that the South Korean shipyards will start doing Navy work. Maybe that's not certainly complex surface combatants, auxiliaries, and support ships, or things like that. So we'll have to see how that plays out. And again, I have not heard any word. I'll just throw this in. There are categories of things that we all forget about South Korea building nuclear subs in the US. You guys remember that? That was a thing for a while. But we've lived a million lifetimes in the last year and a half, it seems.
Just to round off on one thing, the buyback EO, we have not seen anything on execution on that. We've still had inbounds, obviously, I think, headed into earnings season. I don't think managements are going to say anything about that. I'll be curious what they say, unless they've lawyered up and there's some obvious legal chances here. I have gotten the sense that I think the administration may view buybacks differently than dividends. So we'll have to see how that sort of plays out, in fact, or if this is something that was just a shot across the bow to get some companies to the table to be more responsive.
Gautam, would you like to-- if you want to end on that, or anything else?
GAUTAM KHANNA: No, by the way, and I appreciate the amplification and correction. You were absolutely right on the Korean shipbuilders participating in a bigger way over time in the US industrial bases, perhaps as a manufacturer of ships, eventually. In the near term, I view it more as an opportunity for these US guys to actually just improve throughput, which is a good thing because that's their acute problem.
The EO buyback, just on that really quickly, some companies lean into buybacks more heavily than others. As you know, Lockheed has typically spent about $3 billion a year to keep the share count flat. I suspect, like you said, most of these companies are just not going to talk about buybacks or guide to buybacks. I don't think any of them are going to cut their dividends. We've gotten that question. And remember, the EO was written in a way where it seems as though it will be enforced if there's perceived non-cooperation on-- or non-performance on programs.
And so, obviously, this just kind of lights a fire under each of these companies to make sure that they're delivering on time, high quality, et cetera. In other words, it's not to be applied just uniformly across the board to curtail buybacks at these companies, or dividends. It's used as a stick in the event of non-compliance. The other thing I thought was fascinating is, there was also, in that EO, a discussion about executive compensation. And we published something the other day that showed, literally, every one of the CEOs and CFOs of the defense large caps makes more than the $5 million threshold that President Trump laid out in his Truth Social tweet.
And later, it was codified in an EO. Do the boards respond, and how? Because one of the things that was also in that EO was linking executive comp not to financial performance, but program performance. And I am curious if we'll see in the proxies that come out in May, typically, whether we'll see any changes to executive comp to align more with what the EO lays out, as opposed to what has traditionally been financial metrics. That's a TBD, but that will be interesting to see.
ROMAN SCHWEIZER: We've covered a lot of ground, and it is going to be a busy couple of months. So I want to thank all of you for joining us. And this sort of special edition will probably make it a little more less special and more regular. Be careful out there and have some fun. Thanks a lot for joining us, and we'll talk to you soon.