Defense Stocks Post Obama Speech: A Buying Opportunity

Includes: BA, GD, LMT, NOC, PPA, RTN
by: Scott Sacknoff

Is it time to panic? Maybe not so fast.

President Obama got on TV yesterday and announced his debt reduction plans. Although he didn't provide any specifics, many companies operating in the defense sector were down significantly as news sources reported he was seeking $400 billion in cuts over the next 10 years from the Department of Defense. The real question is, what do these cuts actually mean to the companies themselves? Obviously any cut is a negative, but how much a negative? So I decided to go to the numbers and all is not necessarily what it seems. (If you hate math, now is the time to stop reading)

The total proposed defense budget for FY-2012 is $671 billion however, the procurement portion is $113 billion, about 16.8% of the total allocated to the agency. The rest goes mostly toward operations, research, and personnel costs.

If we add up the 50+ firms that comprise the SPADE Defense Index, combined they generated $446 billion in revenues. Once we pull out revenues generated from international customers, civilian government agencies, commercial aerospace, and non-aerospace businesses, we are left with about half. So the revenues generated from either prime contracts or subcontracts issued by or for the Defense Department are about $223 billion. This would give us roughly a 2:1 ratio between the amount budgeted to the Defense Department's "P1" procurement budget and what the companies book as defense sector revenues.

So, the White House's goal is to reduce defense spending by $400 billion over the next 10 years. This averages out to $40 billion annually. I believe that it is highly likely that much of these cost savings will come from changes to the military health care expenditures and the military retirement system as well as savings once we withdrawn troops from Afghanistan and Iraq, but we will ignore this and take the conservative route.

If we prorate the $40 billion over the entire defense budget of $671 billion, we get 5.96%. Based on a P-1 budget of $113 billion and this would translate to a reduction of $6.74 billion annually from procurement. Using our 2:1 ratio and it would mean a loss of $13.5 billion in sales from DoD -- about 3% of total sales by these firms.

In comparison -- the Defense Department announced yesterday that U.S. foreign arms sales is anticipated to exceed $46 billion in FY-2011. In addition, revenues generated from business activities associated with commercial aerospace and information security are expected to grow substantially over the next decade.

Fear may have driven the big five defense sector prime contractors down significantly -- Boeing (NYSE:BA) down 1.30%, General Dynamics (NYSE:GD) down 1.52%, Northrop Grumman (NYSE:NOC) down 2.08%, Lockheed Martin (NYSE:LMT) down 2.56% and Raytheon (NYSE:RTN) down 2.91% -- yet the Powershare Aerospace & Defense ETF (NYSEARCA:PPA) declined by just 1%.

So, armed with the numbers, was it an overreaction?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author manages the underlying index used for the Powershares Aerospace & Defense ETF (PPA)