Along with the rest of the U.S. federal budget, the fiscal 2016 request and plan through 2020 was released on Feb. 2. While there is a consensus that the administration won’t get what it’s requesting because Congress would have to make too many compromises on non-defense discretionary spending, taxes and entitlements, the belief stands that the final figures for fiscal 2016 will fall between the request and the budget caps in the Budget Control Act.

Wall Street is sanguine about the potential compromise because the sum of procurement and research, development, test, and evaluation (RDT&E) budget authority should still show growth over appropriations for fiscal 2015. A common theme analysts are heralding is that investment, which is shorthand for the sum of procurement and RDT&E, has bottomed out and a new up-cycle is about to emerge. This is based on the administration’s plan and is bolstered by views that, as underscored by the atrocities of the Islamic State, the war in Ukraine, conflicts in Yemen and Libya, and simmering disputes in Asia, the world remains a dangerous place. 

While Wall Street may be focusing on budget authority in its belief that the cycle has bottomed, the administration’s projections for outlays show something that many might not consider an upturn. Outlays are a closer approximation to contractor sales from the Defense Department. Budget authority may not expire for several years, so while it might be considered a leading indicator, outlays—which are what the Treasury actually spends of appropriated funds—paint a better picture of industry prospects. In thinking about company growth rates, clearly other U.S. government sales—international defense and commercial—have to be included.

The Office of Management and Budget (OMB) outlay projections released in early February for fiscal 2016-20 for investment show flat outlays in current-year dollars. Fiscal 2015 investment outlays are projected to be $172 billion. They are flat in fiscal 2016 at $172 billion, then increase 1% annually in fiscal 2017-19, with 2% growth in fiscal 2020 and then flat again for fiscal 2021. Those figures are in current dollars and have not been adjusted for inflation. They also reflect the administration’s request and plan, so could be considered a best case. A cut to the fiscal 2016 investment budget authority request will ripple through these outlay estimates. If inflation is 1.8% per year, then in constant dollars over this period, investment outlays slide to $166 billion by fiscal 2020. That’s a downturn in constant dollars.

This “upturn” that is now widely anticipated could also see some other changes. The Defense Innovation Initiative is just getting underway, and teasing out how much funding was allocated in the Defense Department request and plan was complicated by the fact that amounts have not been articulated by senior leadership and because some programs are classified.  As department study groups complete their work in 2015, however, they should be able to better inform the fiscal 2017 budget process.  

One outcome could be more funding for RDT&E to nurture breakthrough weapons programs, though it remains to be seen where this funding could originate. In the first “offset strategy” of the 1950s that department officials talk about, RDT&E in constant dollars more than doubled to $41 billion by 1961 from $20 billion in 1955. That sort of shift was not as apparent in the second “offset strategy,” at least during the gestation periods for GPS, precision strike and stealth. In constant dollars from 1975 to 1980, RDT&E was close to flat, but those efforts seemed more targeted than the sweeping investments in smaller nuclear weapons, ICBMs and air defense of the first offset.

Another outcome is that flat outlays imply that the industry environment is going to remain tough. Arguably, at least as evidenced by the financial health of many public companies, Wall Street could be thinking that a stable, predictable spending upturn could only further support the sales, earnings and cash flows that companies have been producing. However, new program starts are going to be extremely hard-fought and without increased budgets, extensions of mature lines also may be more difficult. Internal investment may matter more as a competitive differentiator.

Finally, department leadership has been signaling loudly that it needs to access commercial technologies. Adding more to RDT&E budgets might help contractors bring more commercial technologies to bear toward solving defense problems. But this “upturn” conceivably could see more commercial competitors emerge if there are real growth opportunities and some of the barbed wire and trenches that have kept them from pursuing defense work are removed. For autonomous systems, satellites and information technologies, there could well be more competition from non-traditional companies.

About that upturn: OMB data suggests there isn’t one. Other trends suggest this is going to be challenging period for heritage defense companies to navigate. 

Byron Callan is a director at Capital Alpha Partners.