Defense Contractors Aided By Congress Keeping Money In Defense Budget

Includes: BA, GD, HII, LMT, NOC, RTN
by: Matthew Potter

The Obama Administration as part of the budget deal last year submitted a 2013 defense spending plan that cuts about $100 billion over the next five years. This was primarily achieved through force structure reductions, changes in personnel benefits and decisions to end or delay some large acquisition programs. Those choices will obviously have a great effect on defense contractors' bottom line. The plans won't start showing an effect until late 2012 when next year's contracts are awarded, or in this case not awarded.

Congress, though, is the final decision maker on the budget. If it makes changes that the Administration does not like it is limited to trying to negotiation them out, or it can veto the final bill or accept them. Historically administrations tend to accept the final bills. Of course Congress is not following plans to reduce overall spending but it has been busy looking for other funding, offsets, to make up for some of its decisions.

The House controlled by the Republicans has been hard at work developing its version of the defense budget and as can be expected it does not agree with all of the proposed cuts. This funding put back in to spending plans, if it holds, will counter some of the negative effects on company bottom lines.

The most recent quarter results have been announced and they were a mixed bag. Lockheed Martin (NYSE:LMT), Raytheon (NYSE:RTN) and Boeing (NYSE:BA) saw an increase in earnings per share primarily due to cost cutting and some selected programs. Boeing is a special case as its commercial aircraft business has seen a very good few quarters with high sales. Part of this is being driven by Chinese opposition to the European Union's "Global Warming" ticket tax as a way to punish Europe and Airbus.

General Dynamics (NYSE:GD) and Northrop Grumman (NYSE:NOC), the two other large hardware contractors for the Pentagon, did have a drop in earnings or revenue for the quarter. GD stated that it was due to slowing contracts from its customers as well as an adjustment for European operations. Northrop despite a small drop in net income and sales being down $500 million reported an increase in earnings per share mainly due to the repurchase of over 4 million shares. Despite the result Northrop is confident it can deliver better than expected for 2012 increasing guidance to 20 to 25 cents.

If the House adds are maintained they will benefit most of the major contractors. It has have for example refused to delay an attack submarine that the Navy requested, adding it back into the 2013 budget rather than wait until 2018. This will add billions ultimately to GD and Huntington Ingalls Industries (NYSE:HII), which built submarines for the U.S. earlier than planned.

The Obama plans also included ending production of a certain version of Northrop's Global Hawk strategic Unmanned Aerial Vehicle (UAV). The Air Force would not build several of the aircraft and retire the ones in use and continues to rely on the U-2/TR-1 reconnaissance aircraft. Northrop was not only losing out on production revenue but also spending to keep the current ones flying and updated. The House went ahead and kept that program going, writing into its bill language preventing the Air Force from making the move. Again this will have a good effect on Northrop.

The Army had proposed ending the development and production of a new missile to replace the current Raytheon Hellfire. This is launched from a variety of aircraft and helicopters and has seen a great deal of use in Afghanistan and Iraq. The new Joint Air-to-Ground Missile (JAGM) was approaching its production decision. Lockheed and a team from Raytheon and Boeing were competing for this next step. The government had conducted a test of both designs recently and the companies had submitted proposals for the Engineering, Manufacturing and Development phase. JAGM, if it goes into fruition, could be $6 billion or more in just production with future billions in support and modernization. Congress seems to have found some money to keep the program going for both teams next year rather then end it. This means that in 2014 and out a decision could be made to move the program into production.

The alternate to this rosy House scenario is that the Senate will not agree with some of these decisions. The defense budget will have to shrink as will all Federal spending in order to reduce the deficits. Compromises could keep some but not all. The current trend of reduced spending, revenue and earnings starting next year will hold. Some of the larger defense contractors could see serious reductions leading to potential M&A activity as in the 1990s or some leaving the market.

Normally in the budget process a compromise is struck. This means that the House might win on a few of its additions. The Senate too will have its own as there are projects near-and-dear to individual members. Ultimately the defense budget will not be as large as it is today but it will not be as small as currently proposed. Some contractors will be lucky and keep programs others will lose.

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