The U.S. defense sector is bracing for turbulence in 2025 as Goldman Sachs downgraded a key player in the industry and reiterated a bearish outlook on other defense stocks, citing risks tied to a slowing Pentagon budget and margin pressures.

The defense budget, which has more than doubled over the past decade, could see deceleration — or even contraction — under the watch of Donald Trump's newly formed Department of Government Efficiency led by Elon Musk and Vivek Ramaswamy.

"We remain cautious on defense stocks as we see decelerating and potentially negative growth in the forward U.S. Department of Defense budget," Goldman Sachs analyst Noah Poponak said in a note Thursday.

Goldman downgraded General Dynamics Corp. GD from Neutral to Sell, citing fundamental challenges across all four of its business segments.

Can The Defense Budget Escape DOGE Spending Cuts?

Goldman warned that defense spending may have peaked, creating "tough compares" for future growth.

Historically, defense spending has moved in decade-long cycles, and the current high base of investment means the next phase could be one of contraction.

Poponak also highlighted the incoming Trump administration appears eager to wind down U.S. involvement in foreign conflicts, further reducing the case for large-scale defense spending.

Poponak indicated the Pentagon's procurement efficiency as "imperfect," which could make defense spending an attractive target for cuts. Given that defense represents a significant chunk of the federal budget, trimming it may be unavoidable as DOGE seeks to deliver cost savings.

“If DOGE wants to substantially reduce total U.S. government spending, it is hard to avoid DoD,” Goldman Sachs wrote.

Structural Margin Pressures And Valuation Risks

Beyond the potential for lower top-line growth, defense contractors are grappling with long-term pressures on profitability. Over the past few years, the Pentagon has tightened contractual terms, effectively shifting cost risks to contractors.

"While the rate of decline may be slowing, we think margins are now structurally lower moving forward vs. the last decade," Poponak said.

DOGE could exacerbate this trend by advocating for more fixed-price contracts, even in the early stages of programs, a move that would further constrain profitability.

Yet despite these challenges, defense stocks as a group continue to trade above their historical valuation averages.

"Defense stocks trade above their historical average valuation level as a group, with some individual names at their high-end and a premium to the equity market," Poponak commented.

Goldman Sachs Reiterates Sell Recommendations On Defense Contractors

According to Goldman Sachs, the General Dynamics downgrade reflects weaker-than-peer growth in its Technologies division, margin pressures in Marine shipbuilding, reduced supplemental funding at Combat, and delivery challenges at Gulfstream that are weighing on profitability.

"While General Dynamics trades at a discount to Lockheed Martin Corp. LMT and Northrop Grumman Corp. NOC, valuation is at a level where it could derate if earnings power is disappointing the market," Poponak said.

Goldman Sachs also trimmed the 12-month price target on General Dynamics from $283 to $245.

Lockheed Martin, often seen as the bellwether of the defense industry, also remains on the Sell list from Goldman Sachs.

The analyst flagged risks related to the F-35 program, which has already been named as a potential target by DOGE leadership.

"LMT currently has a large positive net pension benefit in its free cash flow, and we expect free cash to be near flat the next several years," Poponak said, adding that the company trades at 23 times estimated 2025 earnings, a steep premium for a stock facing margin and spending risks.

Northrop Grumman holds a similar Sell rating, with Goldman expressing concerns about slowing growth in its flagship B-21 bomber program. Poponak highlighted that NOC trades at 20 times the estimated 2025 earnings and warned of "incremental margin risk" ahead.

Huntington Ingalls Industries Inc. HII is also struggling under margin pressures. Its shipbuilding business, plagued by labor shortages and cost overruns, could see profitability erode further, according to the investment bank.

The company's recent results revealed weaker recurring margins than previously assumed, with guidance pointing to near-term margins as low as 5%, far below historical levels.

Goldman also reaffirmed its Sell ratings on L3 Harris Technologies Inc. LHX and Mercury Systems Inc. MRCY, citing slower growth, operational risks, and valuation concerns.

Market Reactions

Shares of General Dynamics fell 1.01% on Thursday, while the broader industry — as tracked by the iShares U.S. Aerospace & Defense ETF ITA – fell 0.64%.

Lockheed Martin fell 1.52%, hitting lows last seen on July 23, 2024.

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Photo: Courtesy General Dynamics