Defense Contractors Stare Down Fiscal Cliff
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Lockheed Martin (NYSE: LMT), America's largest defense contractor, announced on Thursday that unless something is done soon to prevent automatic budget cuts to defense, it may be forced to issue tens of thousands of layoff notifications—mere days before the presidential election. The cuts will begin to take effect in January. Lockheed claims that, due to a law requiring companies to give 60 days notice for layoffs, it is forced to warn all of its employees in early November. Of course, not all these jobs will actually be eliminated in early January, which has led to speculation that Lockheed is using this position as a lobbying tactic, raising the specter of massive job losses to forestall defense cuts. And why wouldn't they? The federal government is the company's largest customer; and the American defense budget is critical to the company's balance sheet. Unfortunately for the defense industry, Lockheed looks unlikely to win this battle. Even if it does, the future looks bleak.
The planned budget cuts were agreed on during last year's debt ceiling debate, and were designed to be so painful that it would force both parties to compromise to avoid them. To nobody's surprise, the parties were unable to agree. Now, unless Congress acts, $600 billion will be slashed from the military's budget over the next decade; on top of $487 billion in cuts already planned. These cuts, once thought too draconian to ever implement, now look increasingly likely to be realized. Senate Democrats have come to view the automatic cuts, dubbed “sequestration,” as an acceptable method to rein in the budget, with Majority Leader Harry Reid saying “I am not going to back off the sequestration…. To now see the Republicans scrambling do to away with cuts to defense, I will not accept that.” Republicans would have to offer major concessions on tax increases and social spending to preserve defense spending, and I don't believe they will.
Traditionally, strong support by Republicans and a solid contingent of Democratic defense hawks was enough to keep defense spending sacred, but these trends are changing. As more attention is drawn to the deficit, Democrats often point to defense as the first thing to cut. The Tea Party, a rising power in the Republican coalition, also seems unwilling to hold defense harmless. Senator Rand Paul, a Tea Party favorite, publicly calls for “conservatives to admit that the military budget is going to have to be cut.” For the contractors, the seeming inevitability of defense cuts poses a problem.
The Pentagon has not produced a plan to absorb the sequestration cuts, meaning that investors don't know what programs are at risk. Firms with more diversified revenue streams would therefore be most sheltered. Boeing (NYSE: BA), for example, generates over half of its revenue from commercial aviation. It also has a massive $380 billion backlog of orders—if it can meet its deadlines and deliver its planes to customers on time, this backlog will provide a multi-year revenue stream no matter what happens to the defense budget. General Dynamics (NYSE: GD) derives about 70% of sales from the US government, but growing sales of private jets and military equipment to US allies could cushion the company's top line.
General Dynamics also makes about a third of revenue from information systems and technology, which are less likely to face budget pressure as cyber-war and technological dominance become more salient to national security. Raytheon (NYSE: RTN) is also heavily engaged in cyber security and information technology, but it has almost no exposure to civilian revenue streams. Its products are in wide use throughout many equipment platforms, meaning that although it is sheltered from any catastrophic cuts to one program, it will be exposed to virtually all reductions in military spending. With around 90% of revenue coming from the US government, it is unlikely that growing international sales will prove sufficient to prop up the company's top line.
The success of other firms are more closely tied to particular programs. Lockheed Martin's F-35 fighter jet, originally planned to be the cornerstone of America's air power and a cash cow for Lockheed, has been criticized as wasteful spending in an era in which America faces no real rivals to its air supremacy. Northrop Grumman (NYSE: NOC), which counts on the US government for over 90% of revenue, also relies heavily on the F-35: it supplies electronic systems for reconnaissance and control to the aircraft. A cancellation or reduction in the program could lead to stagnating share prices for its manufacturers for years.
The US government, which constitutes a near-monopsony on the defense industry, is facing a fiscal crisis. Realistic assumptions envision defense spending falling sharply in 2013, and then growing only “at or near the rate of inflation.” It will be difficult, if not impossible, for defense contractors to outperform in a market where their most important customer can't pay the bills.
Daniel Ferry has no positions in the stocks mentioned above. The Motley Fool owns shares of General Dynamics, Lockheed Martin, Northrop Grumman, and Raytheon Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.