How Will Sequestration Affect the Defense Industry

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This article will focus on how sequestration could affect the defense sector. The failure of Congress and the Obama Administration to craft a “grand bargain” on tax cuts and the federal budget deficit in 2011 pushed lawmakers to pass a sequestration measure.

What is Sequestration?

This is a fiscal policy mechanism where an amount of money equal to the difference between the spending limits set in a Budget Resolution and the amount actually appropriated to federal agencies is “sequestered,” or automatically cut, by the Treasury Department. Previously some observers have considered such a move to be implausible. And lawmakers have repeatedly kicked the can by cutting deals with the White House at the 11th hour.

Now, sequestration looms on the horizon again if a deal is not made by March 1, 2013. Given the current political climate – with the GOP circling the spending cut wagons, while the Democratic-controlled Senate has not proposed a budget in four years, sequestration is a possibility.

In short, the government will need to trim $85 billion in defense and non-defense spending in fiscal 2013 if sequestration takes effect. In particular, the Pentagon could be hit with an automatic 10% cut, which would force the Defense Department to pull back on spending with defense contractors. The ill effects have already hit the sector in the form of preemptive layoffs.

Which Defense Contractors Stand to Lose?

Defense contractors like Lockheed Martin (NYSE: LMT), Raytheon (NYSE: RTN) and Northrup Grumman (NYSE: NOC) expect a decline in profits in the first quarter of 2013.

Lockheed reported fourth quarter 2012 net sales of $12.1 billion compared to $12.2 billion in the same period in 2011.  Net earnings were $569 million, or $1.73 per diluted share, compared to $698 million, or $2.14 per diluted share, in Q4 of 2011. At the end of December 2013 the company was awarded a preliminary contract of $3.68 billion to build 31 F-35 fighter jets for the U.S. military. The deal was to be finalized early this year, but sequestration could scale the program back.

Meanwhile, Raytheon had a profitable year in 2012. The outfit makes the Patriot Missile System that was introduced in the 1991 Gulf War. Since then the company has gone on to provide this and other systems and services to a number of U.S. allies. For 2012, Raytheon reported net income of $543 million, or $1.57 a share, compared with $459 million, or $1.25 a share in 2011.

Both companies said sales would be “flat” this year because of cuts in military spending. But each outfit intends to cut costs by reductions in force and making programs more affordable while looking to international sales to make up for losses in the United States.

As for Northrup Grumman, the company supplies drones (the use of which has become a controversial issue for the Obama Administration), satellites and numerous other products primarily for the DOD and the various intelligence agencies. The company implemented sequestration contingency plans with an initial round of layoffs in Q3 of 2012.

NOC reported an 80 percent increase in 2012 fourth-quarter profit, but revenue was lower. Fourth-quarter earnings were $550 million, or $2.09 a share, compared with $306 million, or $1.03 a share, in the same period in 2011. Like Lockheed and Raytheon, Northrup said earnings and sales would drop this year because of the uncertain military spending environment.

Is Sequestration Inevitable?

Sequestration is not a fait accompli. A compromise short term budget deal could be cobbled together before March 1. Moreover, last week GOP lawmakers in both chambers proposed legislation that would reduce the federal workforce through attrition to avoid sequestration for one year.

The 2013 Down Payment to Protect National Security Act would cut the entire government workforce by 10 percent through attrition at an estimated savings of $85 billion over the next decade. And the Defense Department’s civilian workforce would be cut to its 2009 levels.

In sum, the bill would limit federal agencies to hiring one person for every three employees who retire or leave their job. The hiring reduction would be spread out over the next four to five years, but the savings are designed for a 10 year time period. At the end of the day, if the bill passes (which is highly uncertain), it would only be a stop gap measure that will create more economic uncertainty.

The bottom line: investors in the defense sector should stand pat and hold, as most analysts have suggested, and hope that March 1st brings clarity, if not fiscal sanity. However, fiscal sanity is a rare commodity inside the Capitol Beltway.


kcolona has no position in any stocks mentioned. The Motley Fool owns shares of 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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