The pain of a deep cut in defense would spread across the board.
Posted on 11/05/2011 3:10:43 PM PDT by Kaslin
Circle your calendars for Nov. 23. That's the deadline for Congress to pass -- and the President to sign -- major budget changes being drawn up by a bipartisan "super-committee." Recall that the last agreement, struck in early August, tasked this group with a huge challenge: Come up with a wide range of chosen budget cuts, or live with the consequences of automatic spending cuts that leave no stone unturned.
That's bad news for investors, as we could see history repeating itself in a very unpleasant way.
At this point, Democrats and Republicans are far from an agreement. Democrats have offered up $3.2 trillion in spending cuts, paired with $1.3 trillion in new taxes. Republicans are fine with the spending cuts but insist on no new taxes. Neither side looks ready to blink so far, and it's increasingly looking as if the automatic cuts will be the path.
This is horrible news for the defense sector and investors who hold stocks in these companies. Cuts in military spending already have the support of most Democrats, but a rising number of deficit hawks in the Republican Party are willing to trim Department of Defense (DoD) spending as well. Still, a negotiated budget will be far friendlier to the DoD than the automatic cuts that may take place on Nov. 23. How much are we talking about? About $454 billion from the next DoD budget. That's more than one-third of all planned automatic cuts that would take place. And these cuts come on top of $350 billion in previously agreed-upon cuts as a result of this summer's budget agreement.
The number of soldiers on active duty would likely have to shrink, but it's impossible to quickly shed tens of thousands of soldiers, shutter dozens of military bases and withdraw from key strategic regions around the world. This is a long-term possibility, but not a short-term one. Instead, look for the budget axe to come down hard on defense contractors, all of whom live off lucrative contracts to build billion-dollar planes, ships and security systems. Merrill Lynch says spending by defense contractors will shrink 3.3% annually for the next five years -- and even this number may prove optimistic. Defense spending has risen from 3% of gross domestic product in the 1990s to a current 4.8%. A return to that 3% level represents a 35% drop.
Merrill's analysts note that since Operation Enduring Freedom began in October 2001, defense and security spending has risen 74%. "In our view, this defense budget trend is unsustainable considering the current political and economic backdrop. We expect the budget to decline and revert to the mean, particularly as our operations in Iraq and Afghanistan wind down."
With such a dire outcome coming into focus, it's fairly remarkable that defense stocks are trading as if it's business as usual. Sure, defense stocks have weakened, but not nearly to the extent that you might imagine. In fact, the PHLX Defense Sector Index, which contains a basket of stocks in the industry, remains roughly 100% above the lows seen in 2009.
The pain of a deep cut in defense would spread across the board.
For example:
"Programs that can't meet schedule, that can't meet cost... requirements are very much in jeopardy and will be very much under scrutiny," Adm. Mike Mullen, who recently retired as chairman of the Joint Chiefs of Staff, said at a September Congressional hearing.
The profit impact
Curiously, Wall Street analysts have yet to bake the existing budgets cuts agreed upon this summer, let alone the cuts that may hit the tape after Nov. 23. Lockheed Martin, for example, is expected to see earnings per share (EPS) actually rise 13% in 2012 to a record $8.53, according to consensus forecasts. Raytheon's EPS is expected to rise around 9% to $5.43. Textron's per-share profits are expected to rise 45% to $1.67.
Analysts likely think that any major cuts won't take place until 2013 and beyond, but they probably underestimate the speed with which the Pentagon may move to alter the trajectory of many key programs. Defense Secretary Leon Panetta has already noted that a sense of urgency will kick in once the budget matters are clarified. Like many others in Washington, Panetta has expressed deep concern about automatic budget cuts being enforced, rather than a negotiated solution. Sadly, such an outcome looks less likely with each passing week. With three weeks left to strike a deal, time is running out.
Risks to Consider: It's hard to envision any scenario in which current levels of U.S. defense spending are preserved. Yet foreign sales could take up some of the slack, helping defense contractors keep earnings aloft for a while longer.
Action to Take --> The defense sector may appear cheap, as most stocks trade for a little less than 10 times earnings. But if earnings begin a secular decline, as increasingly looks likely, then such a multiple is no longer quite appealing.
In a recent report, Goldman Sachs neatly encapsulates the gloomy macro picture: The firm is "cautious" on the defense sector because "it's early in a DoD spending downturn, tougher terms of trade with the Pentagon could pressure margins, consensus estimates still embed revenue growth and margin expansion, and valuation is not nearly as inexpensive as it appears."
We'll have a better sense of which defense contractors are most vulnerable to DoD budget cuts in early 2012 as new plans are articulated. Before then, it may simply be wiser to short the iShares Dow Jones U.S. Aerospace ETF (NYSE: ITA), which holds a range of defense stocks. Another option is the PowerShares Aerospace Defense ETF (NYSE: PPA). Even if you're not inclined to short this group of stocks, then it may be a wise time to sell them now if you own shares, as it's hard to see any potential upside in such a challenging environment.
Disclosure: Neither D. Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.
This article first appeared in StreetAurthority: Why Defense Stocks Could get Crushed in Coming Years
but a rising number of deficit hawks in the Republican Party are willing to trim Department of Defense (DoD) spending as well.
Cutting way back on the Defense budget is going to have a significant effect on the unemployment numbers. There are hundreds of thousands of people who work for defense contractors, especially in the metro areas of L.A., Boston, Washington D.C. and many others.
most dire.
If Obama wants to cut defense spending, he has to stop starting new wars and pseudo-military efforts (support to Libya, to fight Lord’s Resistance Army in Uganda, VIPR teams in the U.S.).
you could say the same thing about many government employees. Defense contractors eat up a huge amount of tax money.
“.....and it’s increasingly looking as if the automatic cuts will be the path.”
Wrong.
There will be NO automatic cuts.
Only cuts DISGUISED to look like automatic cuts.
Shameless political camouflage so all involved can shrug and claim, “There was nothing I could do.”
And the sickest news of all...
Government spending, government debt, and money printing will still go up EVERY year.
Of course, the best thing that our government could do, is to dramatically increase defense spending for essentials - in the near term.
Build vehicles; build bomb casings, build artillary; build all kinds of sub-assemblies. But, immediately shrink wrap all this stuff, without tires, batteries, munitions, advanced electronics, perishables. Stuff that would deteriorate or become obsolete in a distant future.
Give us a stockpile of ready weaponry for an unknown future war, with the basic guts of what will be needed.
Employment now; military savings later; with an immediate ability to rapidly mobilize troops for the future hotspots!
Without the defense contractors, you won't have any of the technology that gives our military the edge over our enemies. There are legions of government employees who could be dropped immediately with no impact on our ability to defend the country. Defense is about 18% of the total budget and is one of those items constitutionally authorized. The entitlement programs are the lion's share of the budget and unconstitutional.
how much is needed to defend the country and how much is waste? how many of those highly paid defense contractors actually necessary?
Here's a clue...there are few government employees who can deliver what those contractors provide. Many of the contractors are getting old e.g. 50 to 70 years old. The skills they possess haven't been passed to a new generation to carry them on. Mostly for lack of budget. When the old guys die, so does the technology they provide. Want to build another SR71? Too bad. The ability died with the guys who did it. Do you want enemy aircraft bombing you or would you prefer to have air superiority so that doesn't happen? It's a choice you have to make years before you need it. If you guess wrong, you die.
If I recall correctly, the next generation destroyer (Zumwalt class) was to be constructed at either Bath Iron Works in Maine or Passcagoula in Mississippi.
Well, it turned out that whichever shipyard did not get the contract was likely to get out of the business of building big navy ships. Not enough business to keep going. These were the only two sites in the country that could do it, and one of them (either of them) was on the verge of losing the ability.
The US Navy split the work and gave some to each shipyard. But we are just that close to losing the ability to perform this work.
Similarly -- although the technology is not currently considered worthwhile -- I remember when the USS Iowa (battleship) had an accidental explosion in a main gun turret, it was found that we no longer had the ability to repair it. Couldn't be done, so the ship sailed with two of three main gun turrets operational. Subsequently, the Navy retired all battleships, so the loss is negligible, but nevertheless it tells the story.
It takes decades to get these skills back. We don't have decades. We won WWII in 3.5 years. We couldn't match that performance today.
who is gonna be bombing us? seriously. No country on earth has anything close to the technology to seriously challenge the USAF. Iran? North Korea?
Iran. Surface to surface missile launched from a ship off the east coast of the US. EMP or nuke. Pakistan has multiple subs with 12 nuke capable launch tubes. China has been selling nukes and missiles to Iran. Any technology that we wish to field for the military takes 10 to 20 years from concept to deployment. When you cut the defense funding, the people who are capable of doing the work have to find another line of work. Often you can’t get them back when someone finds money again. The technology is lost and costs more to recover if it can be recovered at all. Our enemies steal our technology. Clinton handed the Chinese ring gyro technology in exchange for campaign cash. That enabled them to put rockets into space and nukes on US soil. Toshiba compromised the propeller milling technology that makes our subs quiet. Now those Paki subs are less likely to be detected.
Western Europe because, come on, in the line of fire before Germany is Poland.
Maybe move them to Poland? I don't know, but I do know Poland would be cheaper than Germany
Ditto for Taiwan -- and my reasoning for that is that the Taiwanese have bankrolled mainland china for more than a decade -- why should we defend them when they have sold themselve out?
I support keeping bases in Japan and S. Korea -- they are strong allies.
Spend more on technology for the infantry -- like for instance, why supersonic jets and not more Warthogs? Why not spend money on super-Kevlar or some such thing to keep the soldiers safe? Make more precision artillery or spend more on that
just my 2 c
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