This defence giant should prosper under Trump

Donald Trump’s Presidency could be great news for defence companies such as BAE Systems (LON:BA.). He is apparently seeking to provide peace through strength. In other words, Trump may desire a larger, more powerful and better-equipped US military in order to deter threats from abroad. Further, he is seeking to rebalance military spending within NATO. He has previously stated that the US may think twice before defending NATO allies who have failed to invest sufficiently in their own militaries.

The end result of higher military spending in the US and across NATO could be higher share prices for defence companies such as BAE. Add to this Trump’s threat to adopt more protectionist trade policies and it is not difficult to picture a more unstable world where military spending rises over the coming years. As such, I believe that BAE could continue to rise following its 11% gain since the US election.

US defence boom

One of the challenges facing investors following Trump’s win is deciding which of his campaign promises will be implemented. Already, he has taken a step back from some of the more audacious ones, such as deporting up to 11 million undocumented immigrants. However, one area where Trump appears to be focused on delivering major change is defence spending.


In his campaign, Trump stated that the US military needed around 90,000 more soldiers, 100 more fighter jets, 350 ships in its navy fleet and improved capabilities in its nuclear and non-nuclear missile defences. Although there are no hard and fast figures for how much Trump plans to increase defence spending, it seems clear that he is determined to not only improve US military capabilities, but to also stimulate economic growth through defence spending. In that sense, Trump is seeking to adopt policies most famously implemented by the Reagan government.

NATO military spending

The Republican Party’s control of the Senate and House of Representatives should ensure that Trump succeeds in increasing US military spending. He may also succeed in forcing fellow NATO members to increase their military spending. That’s because Trump has stated that the US may pick and choose which NATO members it protects in future, based on their military spending figures.

For example, the US spends 3.6% of GDP on the military each year. This may not sound like a large percentage, but the next highest spender in NATO is Greece on 2.4%. The UK is next highest on 2.2%, along with Estonia. Only those four countries plus Poland spend 2% or more of GDP on the military each year out of a total number of 27 NATO countries. This means that 82% of NATO members are not pulling their weight according to Trump’s guidelines, with the President-elect indicating that 2% should be the minimum spend by NATO members each year.

82% of NATO members are not pulling their weight according to Trump’s guidelines

On that basis, it appears as though NATO is at a crossroads. Either its members spend more, or the idea that an attack on one NATO member is deemed an attack on all others will come under serious doubt. Given the potential threat from Russia in Eastern Europe, it would be a gamble for NATO members to do anything but increase military spending over the medium term.

BAE’s position

The defence industry could therefore be on the cusp of a golden age. Although there are no guarantees that this will happen, military spending is likely to increase rapidly once Donald Trump assumes office in January. BAE is well positioned to take advantage of this. The company is a truly global business and is highly diversified. It has operations in land, sea and air, as well as in cyber security. Therefore, it does not require spending to be tilted towards a particular sector, product category or service. BAE should benefit from a general rise in spending across a range of product categories, which would be the most likely result from NATO members increasing the range of their defence capabilities in the coming years.

Despite the improving outlook for BAE and the wider defence sector, BAE has a relatively low valuation. For example, it has a P/E ratio of 14.9 and is forecast to increase its EPS by 8% in the 2017 financial year. Further, BAE yields 3.6% from a dividend which is covered 1.8 times by profit. Therefore, it retains income appeal as well as the potential to record above average EPS growth and a higher valuation over the medium term.

An uncertain world

Alongside the prospect of higher military spending in the US and across NATO members, Donald Trump’s Presidency could heighten global military tensions. For example, he has discussed the prospect of a tougher stance on China from an economic perspective. This could equate to tariffs on Chinese imports, with China likely to respond by placing tariffs on US exports.


Over time, this tit-for-tat behaviour could increase tension between the world’s two largest economies, leading to increased military spending as they seek to assert their positions as global superpowers. In this environment, defence companies such as BAE could win new orders and generate higher levels of profitability.

Outlook

However, that situation may take time to develop. In the nearer term, BAE should benefit from a Trump Presidency which focuses to a greater degree on defence spending than was the case under the Obama administration. While there are no specific figures available at this stage, it seems likely that a prolonged and significant rise in US military spending will commence in 2017.

This is likely to be replicated across NATO members, since Trump’s suggestion that the US may not come to the aid of countries with relatively low military spending may force the hand of the 82% of NATO members which spend less than 2% of GDP on the military each year. This outlook would be positive for BAE due to its diverse operations, appealing valuation and dividend growth potential. Therefore, in my view BAE will deliver high returns as a result of a Trump Presidency.