The United States Department of Defense (DoD) is grappling with some difficult decisions, as both a budget agreement and the enactment of the sequestrations, blunt across-the-board budget cuts, are forcing the organization to make do with less. For these reasons, the 2013 fiscal year (ended September 30th) will be the first one in the 21st Century to see the Department of Defense’s base budget decline, while a special disbursement related to the wars in Afghanistan and Iraq has been decreasing for a few years as the military has scaled back operations there. Altogether, the 2013 budget should be about $600 billion, down from 2010 peak of almost $700 billion. In comparison, China, the second biggest defense spender’s official budget is about $100 billion.
Due to the budget downsizing, Secretary of Defense Chuck Hagel has been rethinking his vision for American defense. A changing geopolitical and technological landscape, and the constrained budget suggest two possibilities, according to Hagel, to rework a defense apparatus inherited from the Cold War. He says this presents an inflection point: The military can evolve into a larger, but less-trained, group or a smaller, high-tech force. In either event, the military’s future manpower looks to be smaller than the present force. Indeed, under current orders, the Army looks to fall to 490,000 soldiers over five years from a recent peak of 570,000. The high-tech path means even more reductions in Army and Marine troop counts, as well as a potential decrease in the number of naval ships. Nevertheless, critics say that Hagel simply gave options, but little visibility, as to the specific effects of the sequesters.
For fiscal 2013, sequestration should bring a total of $37 billion in cuts, with the biggest budget reductions in operations and maintenance. So far, the cuts this year have not seemed to make a drastic impact on either U.S. defense companies or the military’s operations, as the Department of Defense seems focused on cutting overhead. There was roughly $10 billion less spent on procurement, largely hurting Navy shipbuilding, and Navy and Air Force aircraft, according to government sources.
In light of the budget situation, big defense companies like General Dynamics (GD) and Northrop Grumman (NOC) have been focusing on improving margins, as sales have been soft. Meanwhile, there is some risk that big projects like the F-35 jet fighter, the Navy’s Littoral combat ship, and others that significantly support corporate profits could see pressure. That said, with regards to the F-35, considerable funds for Lockheed Martin (LMT) have already been secured before sequestration kicked in. Some companies also are shifting their focus towards more high-tech offerings, in anticipation of military modernization, or out of the defense industry, altogether. iRobot (IRBT), for one, has been building its consumer business.
Next fiscal year, there should be another $52 billion in sequestration reductions, barring any agreement. If that happens, there could be more cuts on training, maintenance, and weapons buying. That said, the Department of Defense may receive more discretion as to how it allocates the decreases.
Out to the early 2020s, the Department of Defense will likely continue to feel fiscal constraint, with the sequestration reducing the budget by a total of $500 billion through that time, on top of about $500 billion already agreed to in a previous budget decision. A new agreement, once reached, could lower the sequester-related figure to $250 billion or even $150 billion, giving the industry some relief.
With the budget issues experienced by the Department of Defense, valuations at defense companies remain well below prerecession levels, though defense stocks have gotten off to a roaring start in 2013. For example, shares of Raytheon (RTN), the maker of Tomahawk missiles, are up almost a third in value. Even as the initial fallout from the sequesters have been overly dramatic here, the future of defense stocks, mostly domestically oriented, seem closely tied with federal budget developments. Subscribers can follow the fates of these companies and this industry, in our reports in The Value line Investment Survey.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.