How Will Supercomittee Budget Decisions Affect The Defense Sector?

by: Scott Sacknoff

I could spend this month’s commentary talking about technical trends, resistance levels, fundamentals, etc. but the reality is, that would be a waste of time -- yours and mine.

It doesn’t matter that the benchmark SPADE Defense Index has rebounded from the summer lows and the Powershares Aerospace & Defense ETF (NYSE: PPA) is at a 50% Fibonacci retracement level, or how the price-to-sales ratio for the sector remains below 1.0 and price-to-earnings near 10. It doesn’t matter. Neither does Boeing (NYSE:BA) forecasts for increasing demand of commercial aircraft; rising acquisition activity [United Technologies (NYSE: UTX) buys Goodrich (NYSE: GR); General Dynamics (NYSE: GD) buys Force Protection (NASDAQ:FRPT); or CACI (NYSE: CACI) raising growth forecasts. It doesn’t matter.

There is no relevant commentary at this time. The only thing that does matter is the Congressional Deficit Reduction Supercomittee and waiting to hear what they come up with. Until they do, everything is just a guess. As one industry executive simply stated, “We cannot predict the output of the Budget Act deliberation or actions of the Super Committee at this time.”

The question is, “Will the sector see manageable reductions on the order of $350 billion through 2023-ish or will an additional $500 billion to a $1 trillion be added to that reduction? Will the budget be essentially flat in real-dollar terms (a budget reduction when factoring in inflation and growth against the current plan) or will the sector see real declines that cause the Secretary of Defense to make significant cuts to programs above and beyond those the sector already anticipates and lead to an estimated loss of one million jobs, a 0.6% increase in the unemployment rate, and put the nation’s security at risk?* -- [* according to various organizations].

The answer is, “I don’t know”. After reading some articles in The Hill, a Congressionally-focused newspaper/blog, even the members of the media don’t know what’s going on inside the supercommittee room. Imagine, the government has actually been able to keep a secret!

As Morgan Keegan defense analyst Brian Ruttenbur said, “The problem I see is uncertainty, uncertainty, uncertainty. Nobody knows what is going to happen.”

Whatever happens, here’s where the first cuts are likely to come from (so you don’t have to take the gloom and doom reporting at face value):

  1. The Army plans to drop to a force of 520,000 troops from the current 570,000; the Marines to 186,600 from 202,000 beginning in 2005.
  2. Health cares costs the Pentagon $50 billion a year; a decade ago it cost $19 billion ($25 billion in 2011 dollars). Expect changes.
  3. Retirement. It’s a given that the formula used for calculating when and how much retirees receive will change to something akin to the calculation that existed a decade ago.
  4. Some programs will see changes -- procurements that slip or are extended a year or two out; decisions to replace needed platforms with existing designs, delaying next generation replacements; and keeping programs that have not yet entered production in development.
  5. A heavier emphasis on out-year reductions with the hope that future budgets could be revised upwards.
  6. Continued emphasis on operational efficiency measures to save money wherever possible without impacting acquisition plans. Eg. Military personnel rotate assignments every 2-3 years, shifting to 3-4 years would save hundreds of millions annually.
  7. Increasing pilot programs designed to reduce the costs associated with supplying energy to military bases and with the transport of materials and supplies around the globe.

So what’s the A&D investor to do? Wait and watch the news. Sigh. Wait and watch the news.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: Scott Sacknoff manages the benchmark SPADE Defense Index and edits the free monthly newsletter "The SPADE Investor". He does not hold positions in any of the stocks in this article or contained in the index.