For the defense sector, this past week was the Super Bowl, the Olympics and the World Cup all rolled into one.
Just as millions transfix on the TV screen watching the competitive sporting event of their choice, so too do defense analysts with the federal budget. The top level and big information has been released but the fine details will slowly emerge over the next few weeks as analysts, investors and company officials determine the winners and losers and look for opportunities hidden in the budget. (FYI: The DoD budget is typically more than 26,000 pages).
There is no more important day for the defense industry than the release of the budget. OK enough hyperbole, let's get into the analysis. (Click to enlarge) 
The Budget
A year ago the sector sold off from its highs (along with the overall market) driven by the fear of anticipated declines in the FY-2011 budget, therefore the details presented in the White House’s plans can be seen as nothing but a positive for the sector with the budget being strong and steady through the middle of the next decade.
An analysis of the out-year budget shows a 13% dip between FY-2011 and FY-2012 before rising steadily over the following three years. This decline reflects reduced supplemental war spending as the U.S. pulls out of Iraq and the 18-month long efforts in Afghanistan and Pakistan wind down. Much of these resources go to personnel, supplies and other items (ie. gasoline and energy needs). Many defense firms have stated that the war effort represents 5% or less of total revenues so the impact from reduced war spending is less than the raw number indicates.
Meanwhile, the core defense budgets grows about $15 billion annually through the middle of the decade.
Overall, defense spending levels for FY-2015 are forecasted to be just 5% less than what is being spent during the peak of the war effort. The White House appears to have incorporated the necessary funds to rebuild and recapitalize the military while still funding future R&D and development efforts. It is nothing short of one of the strongest non-war defense budget ever submitted from the White House.
Combined with companies expanding their focus to compete and operate in non-defense sectors and the possibility of defense firms maintaining future growth becomes highly possible.
Some other items for your consideration:
1. General Science, Space and Technology (non-defense) rises nearly 20% over the five years.
2. There is a minor dip in defense “direct physical” procurement rises from $117B to $147B before dipping to $141B in FY-11. RDT&E holds relative steady at $83B, $83B, and $82B from FY-09 to FY-11.
3. The classified budget (a $40+ billion effort) holds the post-growth levels seen in prior years. (There have been no statements to the contrary and rising expenditures on classified satellite systems and cybersecurity at the NSA and other agencies are not seen to decline).
4. Homeland Security is one of the departments whose budget was not frozen and will see $2 billion added, with nearly half of that amount going into advanced airport scanners.
5. NASA’s budget has been restructured and adds $6 billion over the five years while eliminating a major program creating opportunities for more companies to get a piece of future programs.
6. There is increased spending in what has been deemed “new priority areas”, ie. UAVs, helicopters, cyberwarfare, and activities that focus on agility.
7. Small and mid-size companies should see more opportunities. As such, an increase from the 60 M&A transactions that Houlihan Lokey recorded for the sector in 2009 is likely to rise. (83% of the deals were less than $100 million in value, although valuations were higher with few high-growth companies coming to market.)
8. For large contractors, DoD’s shift from large, multi-billion dollar decade-long "exquisite weapons programs" will lead to increased competition but is not necessarily a negative.
So, although further analysis of the budget is still required, the initial appearance is that this budget should be viewed as a long-term positive for the sector.
Disclosure: No positions, Manager of the SPADE Defense Index
