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Do Tighter Belts Mean Bearish Defense Bets?
The Obama Administration has announced that, as a part of a broader effort to rein in federal spending and reduce budget deficits, there will be substantial military spending cuts beginning in 2013. The budget plan is expected to trim military funding by roughly $450 billion to $500 billion over the next 10 years. However, some argue that such a broad reduction in federal funds for the military could jeopardize national security. Furthermore, from an investor’s standpoint, this could take a considerable toll on regional economies, as well as the large aerospace defense companies that depend on the consistent flow of large government military contracts.
According to recent reports from the United States Department of the Defense (The Pentagon), this plan would likely be painful for many Congressional districts and difficult to manage, but the additional $600 billion in cuts that have been proposed has been described as potentially devastating to national security and the regional economies that rely on the manufacturing operations of aerospace & defense companies, such as Lockheed Martin (LMT), Raytheon (RTN), Boeing (BA - Free Boeing Stock Report), Northrop Grumman (NOC), and Rockwell Collins (COL). There is no doubt that a considerable reduction in government spending on military equipment and technology will slow revenue and order volume for these businesses.
The government is determined to wind down its operations in Afghanistan and Iraq, bringing to a close the decade-long military campaigns in these troubled nations. However, The Pentagon has implied that there will be a shift in focus toward the Asia-Pacific region, as well as other potentially hostile Middle Eastern countries, with an emphasis on a more efficient and agile, but smaller force, concentrated on “peacekeeping” initiatives. There have been indications that spending will now center on highly-skilled special operations units and unmanned operative and cyber technology, such as drones and precision long-range artillery that would allow the armed forces to maintain its dominance and effectiveness, while further reducing the potential for casualties and collateral damage.
Indeed, there is a counter argument that suggests projected non-conflict related military expenditures were expected to grow by approximately 26% out to 2021, from its base of roughly $525 billion to $550 billion in 2012. This would imply that the annual budget would be approximately $660 billion and that total spending would have amounted to something north of $6 trillion. When taking this into account, the $1 trillion cut over the next 10 years seems more like a modest reduction than the catastrophic cut suggested by some.
Nonetheless, the potential detriment to the aforementioned companies has already begun to materialize in the form of slower order volume, unfavorable revenue mix, strained margins, and faltering stock prices. All of the big defense outfits have noted that these planned budget cuts are likely to weigh on performance in the near term. Although the stocks of many of these equities have rallied from their 2011 lows, this news has kept most issues range bound, as investors wait to see how much of a negative impact these new budget plans will have on profitability.
On the other hand, we believe that these companies are already taking steps to widen their customer base and are investing heavily in research and development to launch new products and technologies to help diversify their operations. Some companies have been increasing exposure to the commercial markets to offset probable declines in their government contracts.
All told, we are optimistic about the ability of these businesses to reposition themselves and clear this latest hurdle over the next couple of years. Given the recent positive news about the economic recovery’s ability to gain further traction and the likelihood that heightened global sociopolitical tensions will remain a prioritized concern for the government, we do not believe these proposed budget cuts will do too much to hamper long-term revenue and earnings growth for most of the players in this sector. Indeed, the majors like Lockheed and Raytheon are among the safest equity options in the Value Line spectrum, with generous dividend yields, and appealing price appreciation potential over the long haul.
At the time this article was written, the author had no positions in any of the companies mentioned.