Defense stocks have become collateral damage in the battle raging in Congress over how to reduce the deficit by $1.2 trillion over the next decade.
Any mix of cuts and tax increases will certainly include significant reductions in defense spending. And if the Congressional "super committee" fails to come up with a plan, an automatic "sequestration" will kick in, which calls for half of the money — $600 billion – to come out of defense.
That will come on top of $350 billion in defense spending cuts (also stretched out over the next decade) that were part of this past summer's agreement to raise the debt ceiling.
No wonder the major defense contractors are concerned.
"The defense market is shrouded by the uncertainty," Jay Johnson, Chairman and CEO of General Dynamics Corporation (NYSE: GD) told Politico. "We continue to have no special insight as [to] what the super committee will determine … or what will happen to defense budgets beyond 2012."
While the deadline for the 12-member bipartisan super committee to vote on a plan is Wednesday, it must submit that plan to the Congressional Budget Office today (Monday).
Talk on Capitol Hill last week was anything but optimistic.
Super committee member Sen. Max Baucus, D-MT, was among those expressing dismay at the lack of progress.
"We're at a time in American history where everybody's afraid – afraid of losing their job – to move toward the center. A deadline is insufficient," Baucus told The Washington Post. "You've got to have people who are willing to move."
The urgency of doing something about the federal deficit was underscored last week when it officially passed the $15 trillion mark.
With defense spending already on the decline as a result of the withdrawal of U.S. military forces from Iraq by year's end and the continuing drawdown of forces from Afghanistan, the defense industry has already started to feel the pain.
Lockheed Martin Corp. (NYSE: LMT) laid off 6,500 workers over the summer; its stock is down more than 5% in the last six months. Northrop Grumman Corp. (NYSE: NOC) let 800 people go just last month, and its stock has fallen nearly 12% in the past six months.
Profits at Risk
An adjustment was coming even without a debt problem. While the United States was embroiled in two major overseas conflicts, the defense industry got fat – profits grew from $6.7 billion in 2001 to $24.8 billion in 2010.
Government spending on defense has nowhere to go but down — the only question is by how much.
The cuts implemented as part of the debt ceiling deal over the summer go into effect in fiscal 2012 and will trim the defense budget by 6% to 8%. If the sequestration cuts are triggered, defense spending will fall by 16% in fiscal 2013.
Although some of the reductions will come from operations and personnel, Deutsche Bank AG (NYSE ADR: DB) estimates that as much as 50% of the cuts will come from weapons spending, which comprises just a third of the overall defense budget.
Lawmakers are talking about slashing several of the Pentagon's most prominent weapons systems projects, including the $385 billion F-35 fighter project, the $40 billion Ground Combat Vehicle and Joint Light Tactical Vehicle projects, and possibly the Navy's $34 billion Littoral Combat Ship project.
Reductions in the F-35 would hit Northrop, United Technologies Corp. (NYSE: UTX), and in particular Lockheed, which derived 40% of its profit from the fighter jet in the first six months of this year. Lockheed gets 61% of its revenue from defense contracts.
The two vehicle projects could be totally eliminated, which would hurt both Lockheed (again) and General Dynamics, which gets 44% of its revenue from government contracts.
Diversity as a Defense
All this leaves investors wondering what they should do about defense stocks.
While there's no doubt the government defense pie is shrinking, defense companies that are diversified into other areas are better positioned to endure the siege than others.
The Boeing Co. (NYSE: BA), for example, may see some cutbacks in its new $35 billion KC-X refueling tanker project, but it has a thriving commercial jetliner business. Boeing reported a 30% increase in profits as it saw rising sales of both its older commercial models and its new 787 Dreamliner, which has a huge backlog.
General Dynamics also owns business jet maker Gulfstream, and bought healthcare information technology provider Vangent in September.
Another well-diversified defense company is United Technologies, which announced in September that it is acquiring Goodrich Corp. (NYSE: GR). United Technologies already owns such non-military businesses as Carrier heating and cooling and Otis elevator.
Perhaps the best model of diversity within the defense sector is Textron Inc. (NYSE: TXT). Textron is engaged in commercial aircraft as well as industrial and finance businesses. Better still, 36% of its revenue comes from outside the United States, well above that of most other defense contractors. It even has a small dividend of 0.43%.
Finally, there's one defense stock that stands a reasonable chance of actually benefiting from the actions (or inaction) of the super committee – Rockwell Collins Inc. (NYSE: COL).
"It's levered to replacement parts," trader Brian Kelly told CNBC. "If cuts lead to fewer planes and tanks – the military will need more replacement parts."
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