Why Defense Stocks Could get Crushed in Coming Years

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.

"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.

The Paki stuff is a joke — Chinese made and I doubt it would work. Besides which, to face off against the Chinese and Pakis, it’s not gonna be the US, but India on the front-lines. Let the Indian military pick up the tab.

The Paki subs were designed and built by the French. They can go 12,000 miles without surfacing. France built them in a Paki ship yard, then supervised/trained the Pakis to build two more. A little search with Google will turn up the complete specs.

Frankly, we are much more likely to face a cyber war. It is already underway. Stuxnet aimed at the Iranian nuke centrifuges. Our own power grid control computers are currently infected with a virus thought to be of Russian or Chinese origin. Our grid could be dropped with a few keystrokes. The big transformers used to drive the grid at 750KV and 500KV take 3 years to manufacture and that happens in Germany. We have NO spares. Nail one of those and we have a prolonged outage. Likewise, there are railroad bridges that bring coal to power plants that supply 47% of our electrical power. There is a limit to how much coal each plant can keep on hand. The resupply chain is in constant operation. Wipe out one or more of those bridges and the coal on the ground will be exhausted faster than the bridge(s) can be rebuilt.

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