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What Sequester? Defense Firms Feeling Fine

9 August 2013 in Trading Ideas

The federal budget crunch hasn’t exactly put the squeeze on American defense contractors.

The stocks of many mega-cap companies in the sector have been trading at or near all-time highs following recent quarterly reports that showcased profit growing from a year earlier and boosts to full-year forecasts.

Late last month, Northrup Grumman joined Lockheed Martin in announcing higher quarterly earnings and raising earnings forecasts. Similarly, General Dynamics posted a higher-than-expected quarterly profit and increased its full-year forecast.1

 

Those results have helped boost the company’s respective shares, and they also have provided a lift to the Modern Warfare motif, where those stocks comprise a combined 43% weighting. The motif has risen 10.9% in the past month. During that same period, the S&P 500 is up 3.6%. So far in 2013, the motif has gained 32.3%; the S&P 500 has risen 17.5%.

You could understand how some investors didn’t see this coming. The Pentagon began implementing $37 billion in mandated budget cuts for fiscal 2013 in March, and it faces additional cuts of $50 billion a year over the next nine years unless Congress averts to avoid “sequestration.”

As Reuters reported, Defense Secretary Chuck Hagel has warned that additional cuts for fiscal 2014, which begins this October, would hit the Pentagon’s procurement and research and development budgets disproportionately hard.

However, for defense contractors, the financial writing has been on the wall for the past several years, as the US began to wind down wars in Iraq and Afghanistan. Companies have already been eliminating jobs: Lockheed has cut 20% of its workforce during the past five years, while Northrop has chopped 16% of its employee count.2

And it’s those lowered costs that have been contributing to a healthy bottom line in the near term. Stifel Nicolaus defense analyst William Loomis said results were so positive in the recent quarter because companies had cut costs to get ahead of defense spending cuts that hadn’t yet hit big platforms such as fighter jets, ships and spacecraft. However, companies with shorter-cycle businesses, like services, were starting to feel the pinch, he noted.

Loomis’ longer-term outlook is dimmer, given fiscal pressures and historical trends that showed only wars and major policy changes tended to cause big shifts in the defense cycle.

Northrop Grumman’s chief financial officer, Jim Palmer, may have put it best when asked by Reuters how his company could continue to improve margins in a worsening budget climate: “You have got to continually run as fast as the treadmill is going,” he said.

Future defense budget negotiations figure to be the key determinant of how much margin-squeezing defense contractors will be forced to do.

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1Andrea Shalal-Esa, “U.S. arms makers, boost profits despite Pentagon budget headwinds,” reuters.com, July 24, 2013, http://www.reuters.com/article/2013/07/24/usa-defense-results-idUSL1N0FU22320130724?feedType=RSS&feedName=technologySector&rpc=43, (accessed Aug. 6, 2013).

2Marjorie Censer and Jim Tankersley, “Defense firms weathering budgets cuts more easily than expected,” washingtonpost.com, July 23, 2013, http://www.washingtonpost.com/business/economy/defense-firms-weathering-budget-cuts-more-easily-than-expected/2013/07/23/d23c4f7e-f3b9-11e2-aa2e-4088616498b4_print.html?hpid=z1, (accessed Aug. 6, 2013).

  1. Nagarajan Muthu
    7 Feb at 10:21 pm

    Great Article! The success of defense contractors in FY 2013 was very confusing for me to understand. All the news media focused on defense cuts as part of the sequester sounded really bad for the defense industry; the explanation provided in this article makes so much intuitive sense.

    Reply
    • 11 Feb at 6:09 pm

      Thanks for sharing your feedback. We love hearing from our readers.

      Reply

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