Government-Dependent Industries Feeling the Pinch

Includes: CSCO, GE, NOC
by: Ben Cruz

Lately there has been a recurring theme in the financial media that keeps sounding an alarm over and again: companies that up to this point in the business cycle have depended on government largess will find it difficult to continue to grow.

Take for instance two articles from last Friday’s Wall Street Journal: The first article talks of how Northrop Grumman (NYSE: NOC), a large diversified defense contractor, is considering closing its Avondale shipyard and potentially spinning off its entire ship division which makes, amongst other things, nuclear aircraft carriers. Northrop is one of the companies that benefited from the consolidation that took place in the defense sector in the nineties. By acquiring Litton Industries and Newport News it took on shipbuilding. Today management sees more opportunity in robotics, surveillance and IT than in building planes and aircraft carriers. The article references a White House Commission recommendation to slash $100 billion from the Pentagon budget as one reason why Northrop is shifting strategy. I have followed Northrop for some time and its management team has a great track record for anticipating industry trends and positioning itself around areas of growth. Their ability notwithstanding Northrop will be challenged by deep cuts in the industry. Defense companies who are not as agile as Northrop will suffer even more from budget compression.

In an unrelated article referring to Cisco’s (NASDAQ:CSCO) disappointing quarterly results last week, the WSJ again pointed to the decline in government orders as a red flag. The company saw a decline of 48% from government orders compared to the previous quarter. Cisco generates 22% of revenue from government accounts. The article also mentions increased competition as a reason for Cisco’s guidance below expectations, but the news of the government orders alone was enough to rattle investors.

Listening to its last earnings call, General Electric (NYSE:GE) mentioned that its wind turbines division was underperforming. This was not surprising. Alternative energy is underpinned by substantial government subsidies as renewable energy is costly compared to energy generated through coal, gas and other traditional sources. As government funds dry up Congress will be less and less inclined to continue to support these sources of energy.

I think by now we all get the picture. It is impossible for the US government to sustain its current level of spending. The stated objective of this administration’s spending spree was to jump start the economy with both stimulus money and direct investments to capitalize banks, car manufacturing and insurance companies. The actual efficacy of the emergency measures, although a valid source for debate, will never be known. Economics is not an experimental science. We can not go back in time to 2008 and replicate conditions to know what would have happened if the government had failed to take forceful action. We might have touched depression territory. We’ll never know. In my opinion what matters now is what the government has done, or has failed to do since then. Government spending was supposed to be temporary while the private sector took over and started the virtual circle of hiring workers which increases earning power, which increases consumption, which drives more hiring.

This handing of leadership to the private sector has not happened. Instead we have kept relying on the government and emerging markets to fuel our growth. Take what happened with the housing sector. For some time we were encouraged by a recovery and an up tick on home sales but as soon as the government discontinued the home buyer’s credit, sales went back to below normal levels and home prices to dismal. Let’s not kid ourselves; there is no solution to the housing crisis outside of the market, which necessarily involves foreclosures to work themselves out of the system. Without this there will be no recovery. It doesn’t matter how much money you throw at the problem. You can gain politically from delaying this process, but you will not solve the problem.

Last Friday there was a significant selloff. Investors sold everything from stocks to treasury bonds to gold. The catalysts for the sell off were inflation news from China which might warrant monetary action. The resounding effect was significant. So far companies (especially large multinationals and commodity producers) have largely depended on emerging markets to grow because these countries are still expanding compared to the anemic growth from developed nations. The news from China nullified the gains experienced in the US stock market since the QE2 announcement. This points not only to our connectivity but to the risks inherent in this brave new world.

Fasten your seat belts because the ride will continue to be bumpy until the private sector takes over from the government and becomes the main engine for growth. In the meantime it would be wise to stay underweight in certain sectors that are largely dependent on government, which is showing signs of serious fatigue. Sectors like defense, renewable energy, infrastructure, and healthcare companies that depend on Medicare reimbursements will be squeezed. Of course it would be important to look at each company’s particular set of circumstances but in my opinion we are reaching that point in the business cycle where these sectors are higher risk especially in view of the new set of legislators who will be entering Congress with a different mind set which will make it harder to maintain the current spending levels in Washington.

Disclosure: none