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Defense stocks have rallied over the past two weeks, buoyed by the strength in the broad market. The Spade Defense Index is now re-testing near term highs not seen since the late-summer stock market collapse [click to enlarge]:

Spade Defense Index 1-year chart

1-year chart of Spade Defense Index, courtesy marketwatch.com

As noted, the rise has coincided largely with the renewed optimism for the US economy and the European debt crisis that has driven the market up nearly 9% since Thanksgiving. Yet the rise has also come despite some concerning news for the sector at large:

  • On November 21, the Congressional "supercommittee" mandated by the August debt ceiling deal fails to negotiate the required $1.2 trillion in budget cuts, triggering automatic spending reductions expected to hit defense spending -- and the defense industry -- hard. Defense stocks slide heading into the widely anticipated announcement, bottoming out two days later.
  • On November 28, the Aerospace Industries Association trade group writes a letter to Secretary of Defense Leon Panetta, complaining of changes to Pentagon contracts. The AIA notes concerns about the Pentagon's moves toward making contractors assume more risk for overruns, and threats to withhold funds already approved by Congress for defense and weapons programs.
  • On December 1, Navy Vice Admiral David Venlet gives an interview with AOL Defense, criticizing the production levels in the F-35 Joint Strike Fighter program. "I believe it's wise to sort of temper production for a while here until we get some of these heavy years of learning under our belt and get that managed right," says Venlet. The $385 billion program, led by Lockheed Martin (LMT), with subcontractors including BAE Systems and Northrop Grumman (NOC), is the most costly initiative in the entire Defense Department. 2011 production had already been cut from 42 to 30, according to figures provided by AOL.
  • On December 5, the Pentagon announces a deal with Lockheed Martin on sharing the burden of costs stemming from modifications required after the delivery of F-35 jets -- the same costs Admiral Venlet claimed "sucked the wind out of our lungs" in the December 1st interview. Details of the split were not disclosed, but Lockheed had noted in its third quarter earnings report that it it expected so-called "concurrent costs" to be $1.2 billion by the end of 2011.
  • The same day, Senator John McCain slams the program on the floor of the Senate, calling it "a scandal and a tragedy." McCain had led an effort this summer to cancel the program entirely, and very nearly succeeded.
  • Also on the 5th, Bloomberg reports that the DoD sold $35 billion' worth of weapons to foreign governments, nearly 25% below the agency's target of $46 billion. It also forecasts that sales will slow to $30 billion in FY2012.
  • The next day, Bloomberg reports that the Obama Administration is proposing a five-year budget plan for the DoD with increases capped at or near below the rate of inflation.

To be sure, the bad news is nothing new for the defense sector. Fears of budget cuts and a slowdown in wartime expenditures in Iraq and Afghanistan have been weighing on valuations in defense stocks for some time. Investors need only look at the P/E ratios for the sector's largest, most defense-oriented companies:

Defense Stock Valuations

Company P/E Ratio Forward P/E
L-3 Communications (LLL) 7.68 7.55
Raytheon (RTN) 9.08 8.80
General Dynamics (GD) 9.14 8.67
Lockheed Martin (LMT) 9.73 9.86
Northrop Grunman (NOC) 9.18 8.27

data courtesy finviz.com

In addition, there are some serious questions about Congress' ability to stand by its August agreement to "sequester" future defense appropriations. With 2012 an election year, and the value of defense spending, both at the local and national level, many analysts are projecting that Congress will find a way to avoid the automatic cuts enacted by the Budget Control Act. President Obama has threatened to veto any such workarounds, but will he hold firm in an election year?

Of course, those "cuts" are only cuts in the Washington sense. Defense spending -- even should the automatic spending reductions stay in force -- will still rise, albeit from a lower baseline [click to enlarge]:

Projected Defense Spending

source: Heritage Foundation; does not include authorizations for wars in Iraq or Afghanistan

Still, whether Congress and the President stick to the debt ceiling framework, and whether or not defense cuts are shifted by additional negotiations to entitlement spending, it seems clear that large, costly defense projects such as the F-35 Joint Strike Fighter will come under pressure for the near future. Bulls point to the low valuations and argue that such pressure is already priced in. But there are a number of problems with that argument.

First off, the low valuations are buoyed by cost-cutting measures that have improved margins. Industry layoffs tripled in the first half of the year, and nearly every company in the sector has implemented cost-cutting efforts over the past two years in the face of expected top-line struggles. Yet these efforts have a limit. There is only so much fat that can be cut before growth in the bottom line simply has to match growth on the top line. And with anemic revenue growth, at best in the single digits annually, what kind of earnings expansion can investors expect from the sector?

Secondly, the political winds have shifted dramatically. The public is tired of the wars in Iraq and Afghanistan; the political value of defense spending, while still high, seems far lower than it did just a few years ago. As public attention has turned from overseas conflicts to domestic spending, the Pentagon is no longer untouchable. The criticism of the agency from both sides of the aisle and the growing media commentary on its spending habits show its vulnerability.

More importantly, the interparty dynamics in Washington have changed. As I noted a few months ago when covering home health care stocks:

...[B]usinesses in these sectors have no one left in the political system to defend them. Democrats - particularly the more liberal-leaning in the party - are traditionally less indulgent of, or far more hostile to, business interests than Republicans, depending on your point of view. Yet the GOP -- the traditionally stalwart defender of corporate interests, for good or evil, again depending on your point of view - has made deficit-cutting such a priority as of late that their protection of corporate subsidies can no longer be taken for granted.

The idea that defense contractors will get theirs, somehow, someway -- historically a sensible investment thesis -- finally looks set to change. The most recent defense bill passed by the Senate included a $43 billion reduction year-over-year, and was even $27 billion lower than the amount requested by the Oval Office. Congress may hem and haw, and fiddle around the edges -- but the defense companies' gravy train in Washington has finally jumped the tracks. Congress is cutting authorizations, the Defense Department is negotiating from a position of strength, and a war-weary public cannot be counted on to rally behind increased defense spending.

There is just nowhere for defense contractors to turn. Yes, the P/E ratios are low, and some of the dividend yields -- 5.16% at Lockheed Martin and 3.74% at Raytheon, for instance -- look enticing. But there are good reasons for the valuations. These companies are surrounded on all sides: waning influence in Washington, disappointing demand from overseas governments (many of whom are facing their own budget issues), and a narrowing pool of cost-cutting opportunities. In the short-term, the continued pressure from Washington would seem to preclude any kind of near-term catalyst for defense stocks. For long-term investors, the recent run-up -- 6-8% since Thanksgiving, some 15% since early October -- makes current levels look like a less attractive entry point. Valuations are cheap; but the top- and bottom-line pressures mean that they are not yet cheap enough. The bad news of the last few weeks goes to show that, for defense stocks, things are likely to get worse before they get better.

Source: Warning Signs Are Mounting For The Defense Industry