Editor's Choice

Chuck Hagel and the Worry About Defense Stocks

Nate is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Over at The Washington Post there's a story today about the nomination of Sen. Chuck Hagel to fill the post of Secretary of Defense. Hagel would replace outgoing SecDef Leon Panetta, and there are concerns about the cutbacks that Hagel will be required to make to the budget at the Pentagon.

Let no one lie to you -- budget cutbacks in the defense sector are coming. There's simply no way to avoid it. The current fiscal position of the United States means that cuts are coming for programs, both inside and outside of the defense industries. We can get into the others in later columns, for now I want to focus on which companies should be sweating bullets in the defense sector.

While it might be clear to analysts that the Pentagon is currently facing a problem of its overhead being too high and increasing personnel costs, it's entirely unclear that Congress will allow cuts in pay, benefits or uniformed personnel, even in the wake of the winding down of two wars. While the various service branches are, indeed, drawing down, they're not drawing down to a point that would return to pre-war numbers.

Congress isn't helping, of course. In fact, it's unclear whether members of Congress want to help save money on the Pentagon budget at all. While we all support our soldiers (at least I hope we do), Congress has repeatedly voted raises for soldiers higher than that requested by the Pentagon. When Panetta tried to raise the topic of another round of base closures in 2012, he was told that it wouldn't happen.

That leaves Hagel, or whomever becomes the next SecDef, holding the bag for an organization that will undergo cuts, but must do so in a way that doesn't offend the men and women in Congress, all of whom have an interest in making sure it's someone ELSE who pays the price.

That leaves the contractors, of course. Can't cut staff, can't cut locations, can't cut benefits and overhead ... it's going to be research, development and contractors that feel the ax. Given this reality, I thought I'd lay out for you folks a list of defense stocks that could face market pressure when the Pentagon starts really cutting.

Lockheed Martin (NYSE: LMT): This is, of course, the granddaddy of them all. Lockheed Martin does more than $35 billion worth of business in the arms industry each year and profits run into nine figures. The firm does so much business for the Pentagon that it will be impossible, even with the lobbying muscle that LMT flexes, for the firm to avoid seeing some of its government money go away as the cuts come.

Northrup Grumman (NYSE: NOC): Another one of the monster defense firms, Northrup Grumman specializes in aerospace and engineering. The firm is very vulnerable to large cutbacks in major programs should the Pentagon decide that the way to go is to kill two or three of the very expensive programs instead of spreading the pain out over a wide swath. Plus, JP Morgan Chase analysts say it's trading too high.

General Dynamics (NYSE: GD): Trading flat for the last year, General Dynamics specializes in big hardware for the military. Large combat vehicles such as tanks and ships come out of this top-flight firm. No one doubts the expertise that GD brings to the table, just its ability to defend its programs in the face of cuts that could come to $50 billion per year or more.

L-3 Communications (NYSE: LLL): One that tends to be overlooked, L-3 provides command, control and communications solutions to all of the branches of the military. L-3 is in a special position -- even if their own programs don't get directly cut, cuts in another company's programs could lessen the demand for the software and other items that L-3 provides for the cut programs. Look for L-3 to take a bit of a hit no matter which firms end up on the wrong side of the cuts.

Honeywell (NYSE: HON): Honeywell is vulnerable to cuts largely in Air Force programs. While they provide services and supplies to all the branches, the amount of material they provide to the USAF is staggering. There's simply few aircraft that the USAF uses that don't have Honeywell parts in it. That means that anything that impacts the amount of money spent on aircraft hardware will cut into Honeywell's bottom line. The best they can hope for in that case is to make sure they keep supplying spare parts for existing craft while orders for new ones dry up.

Uncertainty is a part of the process. If we knew what cuts were coming and where, it would be easy to make our way through this. But we can't know those things until they're here. It looks like Hagel will get stuck with the job of making the needed cuts. But without a willing Congress, a Congress that's brave enough to stand in the face of lobbyist money, there's going to be some real doubts about who and what gets cut. Keep an eye on defense stocks and there might be some money to be made there, if you're savvy enough.

More columns from Nate Wooley:

Nate Wooley has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics, L-3 Communications Holdings, Lockheed Martin, and Northrop Grumman. 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!

blog comments powered by Disqus