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Defense Firms Will Stay Aloft

Industry faces short-term challenges, but discipline and strong balance sheets will get companies through.

Basili Alukos, CPA, CFA, 06/18/2013

This article originally appeared in the June/July 2013 issue of MorningstarAdvisor magazine. To subscribe, please call 1-800-384-4000.

Budget cuts and the winding down of wars in Iraq and Afghanistan have many investors wary of the defense industry. To find out whether defense companies can handle these near-term challenges and whether they will have long-term consequences for the industry, I sat down with Neal Dihora, a Morningstar equity analyst who covers industrials, and Rick Tauber, who is Morningstar’s director of corporate-bond research. Our discussion took place April 10.

Basili Alukos: The president released his budget this month, and there’s been a lot of talk about the size of the defense budget. Neal, before we dive in to the sector, how big is the defense budget?

Neal Dihora: The base defense budget is around $530 billion. We’ve seen that number stagnate for about the past three to four years. That does not include war funding, which they designate as “overseas contingency operations.” That’s been running all over the map. We’ve seen it as high as $187 billion. This year, we think it’s going to be closer to $90 billion, or less. We’ve withdrawn from Iraq, and Afghanistan is supposed to be done by the end of 2014. We maxed out the overall defense budget at almost $700 billion in 2010 when we had the surge in Iraq.

Alukos: What about the effects of sequestration and the implications of longer-term defense spending in light of our government looking to cut costs?

Dihora: There’s this misperception in the marketplace that defense is going to get cut by $1.2 trillion over 10 years. If you look at the raw numbers and assume that the fiscal 2013 baseline defense budget was $530 billion, even after sequestration, we’ll have $480 billion of spending to do. It’s a real cut of 9% in the interim, and then we get back to $500 billion by 2016. We’re not really cutting $1.2 trillion out of anything. We’re $1.2 trillion from a trend baseline that was created before. The sequester brings us to a new baseline. So, we’re going to start from that $530 billion, we’re going to cut what we think needs to be cut in one or two years, and then we start growing again.

A new baseline is not the worst thing for defense contractors, as long as they’re able to manage their costs to it. They’re not in the same situation that they were in the 1990s, which is when the last big defense cuts happened, what the industry calls the “Last Supper,” when 15 industry CEOs were told by the Department of Defense that the budget was being substantially cut post-Gulf War I.

Companies started consolidating, took on a lot of debt, and before 9/11 happened, they were struggling. We circle to today, and there are only five prime defense contractors: Boeing BA, Lockheed Martin LMT, General Dynamics GD, Raytheon RTN, and Northrop Grumman NOC. None of these players has a whole lot of debt. They’re in a position of pretty strong financial strength. If they can manage their cost base to the revenue opportunity, I think the stocks are going to be pretty interesting.

Basili Alukos, CPA, CFA, is a stock analyst with Morningstar.
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