Military Cutbacks Means Shorting Defense Contractors

Includes: GD, ITA, NOC, RTN
by: Nicholas Pardini

Heightened government spending since the start of the Bush administration has been a boom for defense contractors as wars in Iraq and Afghanistan have fueled the need for weaponry and military technology. However, the tides are changing for the future of defense spending. The low probability of a war with Iran, increasing anti-war sentiment, and fiscal issues within the federal government make me bearish on the defense sector.

The main driver of defense contractors' earnings is government spending. For leading defense contractors, direct U.S. government purchases averages around 80% of revenue [Raytheon (NYSE:RTN) 78%, Northrop Grumman (NYSE:NOC) 90%, and General Dynamics (NYSE:GD) 75%]. With the U.S. military presence scaling back in Afghanistan and Iraq, expect defense spending to be cut. Automatic defense cuts from the failure of the debt ceiling committee will also hurt revenue. With debt levels breaking 100% of GDP, the U.S. government will have to make hard choices on both defense and entitlement spending.

War with Iran is the one caveat that could derail a short on defense contractors. However, a war with Iran is highly unlikely. Even though Muslim extremists rule the country, the current regime nonetheless is still a group of politicians. Iran realizes that any attack on Israel, Saudi Arabia, or the U.S. will result in a nuclear annihilation of their country. The prospect of mutually assured destruction alone will prevent a war with Iran unless if the U.S. strikes first. This is also unlikely because of the political unpopularity of wars in Afghanistan and Iraq and the current fiscal situation of the U.S. government.

Despite trading at relatively low valuations, defense contractor stocks will underperform the market in 2012. The prospect of reduced military spending and these companies' dependency on the U.S. government for revenue will cause severe cuts in earnings and future expectations. Of all of the government's fiscal commitments defense spending is the easiest to cut because it has the least direct effect on the American people versus entitlements.

Several steps have already been made to reduce the future scope of the U.S. military. The Obama administration has already committed to a withdrawal of troops in Iraq and also expects to cut the overall troop count by 14% with the support of leading military officers. Debt ceiling compromises and other budgetary pressures have led to the Pentagon having its annual budget reduced for the first time since 1998 and it is expected to be cut by a total of $485 billion over the next 10 years. Public sentiment has shifted to less military intervention as polls show that most Americans disapprove of military action in Iran and favor leaving Afghanistan. The culmination of public sentiment and financial austerity will shift the priorities of government away from the military at the expense of defense contractors.

The way investors can capitalize off this trend is by either shorting a defense sector ETF such as the iShares Aerospace and Defense fund (NYSEARCA:ITA) or (after some due diligence) shorting the biggest individual names in the defense sector such as Raytheon , General Dynamics or Northrop Grumman. However, avoid shorting defense contractors that have a large portion of their revenue coming from robotics or cost saving technologies such as Aerovironment (NASDAQ:AVAV). Technically, defense companies look weak as well. The MAC-D has crossed bearish and both slow and fast stochastics are just starting to break below overbought territory. The ITA ETF also faces stiff resistance at $65 per share.

Disclosure: I am short ITA.