Slow Going for Defense Contractors

09/27/2011 7:30 am EST

Focus: MARKETS

The US spends more on defense than the next 21 nations combined, and it represents 4.7% of GDP, so defense spending (and cutting) is a major economic issue, write Neal Dihora and Rick Tauber of Morningstar StockInvestor.

We’ve updated our forecast for defense budget changes following the passage of the Budget Control Act of 2011, which proposes to save around $350 billion from defense-related expenses as part of the $917 billion in total US budget cuts over ten years that allowed the debt ceiling to be increased.

This is followed by up to $600 billion in additional defense spending cuts, as part of the $1.2 trillion to $1.5 trillion in reductions over ten years that will allow a further debt ceiling increase. We look at three cases in an attempt to further understand the size and scope of cuts, and their impacts on our defense coverage list.

We believe the savings embedded in the Budget Control Act are quoted from a baseline projection. To derive a baseline estimate, we begin with the fiscal 2012 defense budget proposal, which includes $553 billion in the base budget and $118 billion of overseas contingency operations (OCO) spending.

The impact of reductions to the defense industry will be larger than to the overall DoD budget because personnel pay is excluded from budget cuts. In our projections, we grow personnel costs by 3% per year, assuming cost of inflation pay increases and faster health-care cost increases, while adjusting for troop level changes as outlined in the fiscal year 2012 defense budget.

We allow the following three line items to accept the proposed cuts: operations and maintenance; procurement; and research, develop­ment, test, and evaluation (RDT&E). Our under­standing is that most companies we cover receive revenue from these portions of the DoD budget.

Case 1
A baseline budget that includes a five-year gradual decline in OCO spending along with 1.5% increases in the base DoD budget. We then implement $600 billion of cuts over ten years, from fiscal 2013 through fiscal 2022.

The cuts start small and escalate. For example, the first five years include $195 billion of the $600 billion in total cuts. The results show an annual decline to the DoD budget slightly below 3% through fiscal 2018.

The three line items we feel are more related to defense-industry revenue are expected to decline by around 5% annu­ally through fiscal 2018. Under this scenario, we feel public companies would potentially reduce head count in the 5% area to match staffing with the lower revenue opportunity, thereby maintaining operating margins.

However, the operating margin results would also depend on strategic decisions by individual companies. For example, a company could decide to spend on research and development, which would lead to lower operating margins but could generate additional revenue through market share gains.

Case 2
This could be considered the bullish case, as we exclude OCO in our baseline altogether, and only reduce spending by $350 billion. This leads to posi­tive budget growth for the DoD and an essentially flat outlook for the defense industry.

This case is predicated on the fact that in the past Congress has not been successful in cutting budgets, especially those of the automatic stabilization variety. The overall DoD budget excluding OCO, which is $553 billion in fiscal year 2012, would increase every year and end at $618 billion, including the proposed $350 billion in cuts.

We believe that companies may point to this scenario when making macro comments on the budget, as it does present a budget that Congress will score itself against, and promotes a more opti­mistic view of the revenue opportunity.

NEXT: Case 3

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Case 3
The final case represents a bearish take on the outstanding proposals. First, we include an aggressive three-year withdrawal from current wars and cut the DoD budget by $950 billion over ten years.

Stepping back, this scenario could be the most likely, as the president has a desire to pull out of the Middle East conflicts and Congress appears willing to allow spending cuts to flow through, even to “sacred cows” such as defense and Medicare.

Our estimate is for a 5% average reduction to the overall DoD budget and a dramatic 8% reduction to line items important for the defense industry over the next five years. This is possible in our view; we saw a 5% to 6% reduction in the defense budget during fiscal 1991, 1993, and 1994.

It appears difficult to have so many sequential down years, and defense contractors would really be limited in their ability to grow. This could lead to another round of mergers and acquisitions with the blessing of the DoD, most likely with smaller players combining forces or prime contractors—Lockheed Martin (LMT), Boeing (BA), General Dynamics (GD), Northrop Grumman (NOC), and Raytheon (RTN)—purchasing unique technologies.

Other Factors
The DoD is also considering mechanisms to reduce spending beyond program cancellations and procurement reductions. For example, increasing the use of fixed price contracts limits the risk of cost overruns by the contractor.

On the flip side, the defense company is taking on more risk without offsetting reward. Many large and high-profile programs have experienced large cost overruns that have been funded by the DoD.

For example, Boeing has spent too much money on the Ground Mobile Radio portion of the Joint Tactical Radio System program. The Joint Strike Fighter program run by Lockheed Martin is also experiencing cost overruns.

We have also read that the DoD may change its view on working capital funding to defense contractors. In the past, defense contractors have used lack of working capital needs as a factor in accepting lower operating margins but worthwhile returns on invested capital.

We expect more information regarding the size and scope of budget cuts over the remainder of the year. Namely, new Secretary of Defense Leon Panetta needs to spend considerable time wrestling with fiscal spending realities and merging these with national security priorities.

Further, the Congressional panel of 12 authorized to determine the $1.5 trillion in spending cuts must present its recommendations to Congress before December 23 for a vote. These could contain more, less, or the same $600 billion in defense spending cuts as the fallback $1.2 trillion plan. All of these must then be balanced with the ongoing conflicts in the Middle East and elsewhere to result in a firmer defense budget.

Even so, with a potential change in the presidential administration in 2012, further changes could occur. Needless to say, the process will be fluid, and our estimates can change accordingly.

The one certainty over the near term is an increase in uncertainty. The past six months brought the US to the brink of potentially defaulting on its obligations.

With our new, lower base-case revenue forecasts derived from this top-down viewpoint, we have adjusted our projections, and this resulted in across-the-board decreases in our fair-value estimates for the industry.

Lockheed Martin saw the largest reduction, to $71 from $100. We also cut the fair-value estimate of the other wide-moat defense firm, General Dynamics, to $75 from $85.

Of course, we had already forecast minimal growth in defense spending, but we are simply taking another cut to our revenue forecasts here, following the President’s signing of the Budget Control Act.

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