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By Lorenzo Beriozza

The major players in the defense space in the U.S. have experienced a significant outperformance of their share prices against S&P 500 lately. The numbers speak clearly.

The possible drivers of the price rally can be found in the folds of their financial statements as well as in the constant surge of the U.S. defense budget of the past years.

An industry protecting its wealth

The "defense gorillas" (and the metaphor is not meant to sound intimidating) have been paying generous dividends to shareholders, thus making them attractive for long portfolios seeking constant cash returns, such as Lockheed Martin (NYSE:LMT), which has an average yield of 3.40% over the past 5 years. Whether the dividend policy is dictated by healthy balance sheet or a shrewd, carefully designed strategy aimed at retaining and attracting shareholders, it does not ultimately matter. They pay good money. And the flow has been steady.

Unsurprisingly, they have also launched massive buy backs where billions of dollars were spent trying to sustain their share prices, a prime example being General Dynamics (NYSE:GD) as represented in the below comparison chart. The defense sector abounds of rumors and speculations, particularly with respect to potential budget cuts and reorganization of the public spending. Countering these centrifugal forces may prove to be a challenging task, and buybacks represent a good antidote. Of course, the precondition is enjoying a cash rich position, with lacking potential alternative investments, seems to be the case.

Lastly, a close look at the financial statements reveals most of them can count on solid, funded backlog of signed contracts with the U.S. administration, which translate into steady cash flows for the quarters to come.

Does this sound like the perfect, everlasting equilibrium? Not so fast. A number of factors are silently eroding the solid basement upon which these companies have based their success.

No more unlimited ammunition

The defense budget is expected to be curtailed in the next decade and will have to compete with other entitlement accounts such as Medicare, Medicaid, Social Security, etc. The upcoming U.S. Presidential Election will provide a first (and undisputable) indication as to the magnitude and the composition of such budget cuts. To put more wood on the fire, the portion of the defense budget linked to "OCO" (Overseas Contingency Operations) is expected to decrease significantly in the next years. The planned foreign policy objectives (e.g. U.S. troops withdrawal from Afghanistan, etc.) leave no room for misunderstanding.

Additionally, despite the stock prices have resisted well, the outperformance is financially unsustainable for a prolonged period of time. Cash rich balance sheets might quickly turn into bottomless wells where cash will be drained to cope with contract cancellations, puzzled shareholders searching for alternative investment opportunities, and the likes.

Homeward bound…

The historical dependency on U.S. market offers little or no opportunity to gain market share outside the U.S. Despite a weak U.S. Dollar, which could favor the U.S. weapon suppliers, this substantial opportunity will be missed as the reconversion from domestic production to international markets will be outpaced by the evolution of the U.S. political and economic events.

Empire building in uncharted waters

If this is not enough, the equation must factor in the undergoing industry consolidation, which is generating opportunities for acquisitions as well as for business portfolio diversification towards sectors where existing capabilities can be exploited. This does not necessarily come without risks. Such business stretches entail discounting unfavorable factors: the cost opportunity associated with alternative investments (i.e. is diversification really the driver to achieve sustainable cash flows?) and the inexperience in the new sector, just to name a few.

On the other hand, undiversified companies such as Oshkosh (NYSE:OSK) may be at risk still due to their dependency on the U.S. government spending and one specific product type. Thus presenting a great short selling target.

Overall the picture above should suggest the outlook for the defense companies will rapidly become uncertain. And uncertainty, as we know it, may bring surprises.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.