Defense Companies Under Fire

By Tony Daltorio - June 25, 2012 | Tickers: KBR, LMT, MANT, NOC | 0 Comments

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As many investors in the sector already know, military spending cutbacks loom over the defense industry. Pentagon spending going forward may be slashed by up to $500 billion. That is why the largest defense contractors including Lockheed Martin, Boeing, General Dynamics and Raytheon spent a combined $33.4 million on lobbying in the nation's capital last year, hoping to pare the cuts. And defense company spending on Washington lobbying has increased even further this year. 

Most investors, however, are unaware that thanks to the wars in Iraq and Afghanistan, the boom in military spending was particularly profitable to a specific segment of the sector...the military service companies. Any severe cutbacks in the Pentagon's budget will greatly effect their bottom line and therefore stockholders in these companies too. 

For once, a ratings agency seems to be ahead of the game. Moody's is well aware of the potential severe effect cutbacks will have on these firms, stating in a recent report that a decline of 5 percent or more in the Pentagon's budget could leave the firms “at the risk of a downgrade.” Moody's warns that revenue and margin pressure will soon become visible to everyone, despite the companies' continued bullish outlook. 

One of the major pressures arising for these military service firms is the fact that the Pentagon is pushing hard for fixed-price contracts, meaning that any cost overruns will have to be born by the firms themselves. Another pressure point is that many military contractors took on a lot of debt during the boom years, apparently expecting the good times to last indefinitely. 

So what are some of the companies Moody's is talking about? At the top of the list certainly has to be KBR Inc. (NYSE: KBR) which may be better known to some as Kellog, Brown & Root. According to government reports, it was the top defense service contractor for the wars in Iraq and Afghanistan, earning $40.8 billion over the past decade. But at least KBR did not add a lot of debt. The Moody's report specifically pointed to ManTech International (NASDAQ: MANT) as one of the most exposed contractors because it added a lot of debt in recent years. ManTech supplies technologies and solutions for national security programs. It is trading barely above its 52-week low of $21.12 a share and at its lowest level since 2005.  

Let's not leave out the big defense contractors in this discussion either. Some of them, including Lockheed Martin (NYSE: LMT) and Northrup Grumman (NYSE: NOC), do have big military service divisions and will suffer a double whammy if there are serious cutbacks in the US defense budget. In the first quarter of 2012, NOC reported sales of nearly $2.6 billion for their information systems and technical services divisions versus sales of $6.7 billion overall. Meanwhile, LMT reported overall net sales of $11.3 billion with their information systems and global solutions division supplying about $2.1 billion of that amount.   

Of course, these firms are much more diversified and financially strong, making them better able to survive lean times. The same cannot be said of the pure defense service firms. Their lack of diversification and dependence on rising Pentagon budgets leaves KBR and MANT vulnerable to further falls in their share price (both are already near their 52-week low). The weakness in these stocks is likely to continue for the foreseeable future and, at the least, up to the November election. 

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