Pension Plans, Aeroplanes And Government Contractors

Includes: BA, GD, LMT, NOC, RTN
by: Mel Daris

By Renee Ann Butler

A company can only lower its costs as low as its employees and suppliers allow. There is a point at which making such cuts become a greater cost, such as in inferior supplies or angry workers. Boeing Co. (NYSE: BA) is learning this lesson all too well.

The company "is entering the final weeks of tense contract talks with its 22,000 engineers that are testing its new commercial-aircraft chief and could significantly affect its efforts to drive down costs to develop new jets," writes the Wall Street Journal. "The negotiations are to replace the contract that expires Oct. 6 for the Society of Professional Engineering Employees in Aerospace, Boeing's second-largest union, whose members design, test and help produce Boeing's jets."

Leaders of the union are claiming that Boeing has yet to disclose the specifics of its bargaining position but instead is "using their weekly meetings to lecture the union." The Wall Street Journal notes, "Ray Goforth, Speea's executive director, calls recent sessions 'utterly useless and insulting,' and has warned of a possible strike vote if negotiations continue to deteriorate."

If Boeing fails to reach a deal with the union, it would be "the first strike at Boeing since assembly-line workers walked out four years ago, and the first strike by the engineers since 2000" but it would also "disrupt or even halt manufacturing at a time when Boeing is racing to meet a record commercial backlog of approximately 4,000 jets valued at $302 billion, based on contract prices. It also would slow the development of new models, including the already-delayed larger version of the Dreamliner, the 787-9, due for delivery in 2014."

Moreover, while delays can be costly, the big issue here is whether Boeing will lose market share because of the delay. Lockheed Martin Corporation (NYSE:LMT), Northrop Grumman Corporation (NYSE:NOC), Raytheon Co. (NYSE:RTN) and General Dynamics Corporation (NYSE:GD) could easily step in to the hole left by Boeing delays, and that is to say nothing of the privately-owned Airbus. Granted, if the union strikes down Boeing's offer, it doesn't necessarily mean a halt in production, but the longer negotiations take the more likely there could be some interference in production. If this happens or looks likely, why wouldn't a potential customer look toward one of Boeing's competitors?

Boeing has a much larger market capitalization than its rivals, boasting a size that is more than double that of General Dynamics, Northrop Gruman and Raytheon, and 40% larger than Lockheed Martin, but that doesn't mean the issue of pensions is any less prominent.

A report from Moody's Investors Service said in early August that pension plans - one of the primary points of contention in union negotiations - could end very soon for Lockheed Martin, Boeing, Northrop Grumman and Raytheon "because the companies have large pension obligations relative to their market capitalization, they're good candidates for selling their pension plans to annuity firms," reports the Washington Business Journal. "In the case of the five defense contractors named in the report, Lockheed's obligations amounted to 125 percent of its market capitalization at the end of 2011. The obligations at the other four were 128 percent for Northrop, 108 percent for Boeing... and 108 percent for Raytheon."

Should this happen, the change would "affect current employees who were grandfathered into their pension plans before the companies switched to alternative retirement programs," says the Washington Business Journal. "Those employees would no longer accrue benefits - though they would receive all benefits owed up until the point of termination, as required by federal law. Presumably they would be eligible to participate in the companies' alternative retirement plans, like a 401(k) plan." So far, many of these companies have said that no plans to do so - Lockheed Martin told its staff in a statement posted online in April that "there are no plans to freeze your plan or sell it off" - but at this level of exposure, those promises may not be a possibility, especially after next year when roughly $1.2 billion in federal cuts are expected to take effect.

According to theLos Angeles Times, "The new cuts are part of an automatic round set to take effect in January if Congress fails to reach an agreement on reducing the mounting federal deficit." Under the law, federal funds would be "sequestered" or held back "until there is agreement, at which time the funds may or may not be reinstated." If sequestration occurs, the Aerospace Industries Association predicts that 1 million jobs would be cut nationwide. "Pentagon boosters in Congress, including Rep. Howard "Buck" McKeon (R-Santa Clarita), chairman of the House Armed Services Committee, are also issuing stark warnings." McKeon recently said, "Congress is playing political chicken with people's jobs. The clock is ticking."

So, how will this affect investors? The simple answer is that it might not weigh in at all if Congress takes action and these companies work to maintain their existing pension arrangements. However, issues such as these are never simple, especially when so much is at stake. Eventually, the bottom line will win out. I recommend investors look toward companies that have less exposure in terms of pension obligations over market capitalization and a strong business outside government contracts.

Raytheon has almost 80% of its revenue stem from government contracts. Government spending is responsible for closer to 85% of Lockheed Martin's revenue and closer to 90% of Northrop Grumman's revenue. General Dynamics is a little better at roughly 75% of its revenue coming from U.S. government spending. Compare this with Boeing. Military aircraft accounted for roughly $15 billion in revenue for the company in 2011, compared with total revenue of $68.74 billion (around 22%), making it less vulnerable to Congressional actions than its competitors.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.