Circle your calendars for Nov. 23. That's the deadline for
Congress to pass -- and the President to sign -- major budget
changes being drawn up by a bipartisan "super-committee." Recall
that the last agreement, struck in early August, tasked this group
with a huge challenge: Come up with a wide range of chosen budget
cuts, or live with the consequences of automatic spending cuts that
leave no stone unturned.
That's bad news for investors, as we could see history repeating
itself in a very unpleasant way.
At this point, Democrats and Republicans are far from an agreement.
Democrats have offered up $3.2 trillion in spending cuts, paired
with $1.3 trillion in new taxes. Republicans are fine with the
spending cuts but insist on no new taxes. Neither side looks ready
to blink so far, and it's increasingly looking as if the automatic
cuts will be the path.
This is horrible news for the defense sector and investors who hold
stocks in these companies. Cuts in military spending already have
the support of most Democrats, but a rising number of
hawks in the Republican Party are willing to trim Department of
Defense (DoD) spending as well. Still, a negotiated budget will be
far friendlier to the DoD than the automatic cuts that may take
place on Nov. 23. How much are we talking about? About $454 billion
from the next DoD budget. That's more than one-third of all planned
automatic cuts that would take place. And these cuts come on top of
$350 billion in previously agreed-upon cuts as a result of this
summer's budget agreement.
The number of soldiers on active duty would likely have to shrink,
but it's impossible to quickly shed tens of thousands of soldiers,
shutter dozens of military bases and withdraw from key strategic
regions around the world. This is a long-term possibility, but not
a short-term one. Instead, look for the budget axe to come down
hard on defense contractors, all of whom live off lucrative
contracts to build billion-dollar planes, ships and security
systems. Merrill Lynch says spending by defense contractors will
shrink 3.3% annually for the next five years -- and even this
number may prove optimistic. Defense spending has risen from 3% of
gross domestic product in the 1990s to a current 4.8%. A return to
that 3% level represents a 35% drop.
Merrill's analysts note that since Operation Enduring Freedom began
in October 2001, defense and security spending has risen 74%. "In
our view, this defense budget trend is unsustainable considering
the current political and economic backdrop. We expect the budget
to decline and revert to the
, particularly as our operations in Iraq and Afghanistan wind
With such a dire outcome coming into focus, it's fairly remarkable
that defense stocks are trading as if it's business as usual. Sure,
defense stocks have weakened, but not nearly to the extent that you
might imagine. In fact, thePHLX Defense Sector Index , which
contains a basket of stocks in the industry, remains roughly 100%
above the lows seen in 2009.
The pain of a deep cut in defense would spread across the board.
Boeing Co. (
currently has 30,000 workers employed on next-generation airborne
refueling tankers. This is a pricey project that was already
hampered by a lack of widespread support at the Pentagon.
Textron Inc. (
's V-22 Osprey tilt-rotor aircraft program may also end up on the
General Dynamics (
may lose a lucrative contract to upgrade Abrams tanks.
Patriot missile system may also be sharply pared back.
Lockheed Martin (
Northrup Grumman (NOC)
and BAE Systems have all heavily invested in the F-35 joint
strike fighter program, which is already plagued by massive cost
overruns. This makes it an easy target for budget cutters at the
Pentagon. At its current pace, the program could cost $1 trillion
during the next 10 years unless it's scaled back.
"Programs that can't meet schedule, that can't meet cost...
requirements are very much in jeopardy and will be very much under
scrutiny," Adm. Mike Mullen, who recently retired as chairman of
the Joint Chiefs of Staff, said at a September Congressional
Curiously, Wall Street analysts have yet to bake the existing
budgets cuts agreed upon this summer, let alone the cuts that may
hit the tape after Nov. 23. Lockheed Martin, for example, is
expected to see
earnings per share (EPS)
actually rise 13% in 2012 to a record $8.53, according to consensus
is expected to rise around 9% to $5.43. Textron's per-share profits
are expected to rise 45% to $1.67.
Analysts likely think that any major cuts won't take place until
2013 and beyond, but they probably underestimate the speed with
which the Pentagon may move to alter the trajectory of many key
programs. Defense Secretary Leon Panetta has already noted that a
sense of urgency will kick in once the budget matters are
clarified. Like many others in Washington, Panetta has expressed
deep concern about automatic budget cuts being enforced, rather
than a negotiated solution. Sadly, such an outcome looks less
likely with each passing week. With three weeks left to strike a
deal, time is running out.
Risks to Consider:
It's hard to envision any scenario in which current levels of
U.S. defense spending are preserved. Yet foreign sales could take
up some of the slack, helping defense contractors keep
aloft for a while longer.
Action to Take -->
The defense sector may appear cheap, as most stocks trade for a
little less than 10 times earnings. But if earnings begin a secular
decline, as increasingly looks likely, then such a multiple is no
longer quite appealing.
In a recent report, Goldman Sachs neatly encapsulates the gloomy
macro picture: The firm is "cautious" on the defense sector because
"it's early in a DoD spending downturn, tougher terms of trade with
the Pentagon could pressure margins, consensus estimates still
embed revenue growth and
expansion, and valuation is not nearly as inexpensive as it
We'll have a better sense of which defense contractors are most
vulnerable to DoD budget cuts in early 2012 as new plans are
articulated. Before then, it may simply be wiser to short the
iShares Dow Jones U.S. Aerospace ETF (ITA)
, which holds a range of defense stocks. Anotheroption is the
PowerShares Aerospace Defense ETF (PPA)
. Even if you're not inclined to short this group of stocks, then
it may be a wise time to sell them now if you own shares, as it's
hard to see any potential upside in such a challenging
-- David Sterman
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold
positions in any securities mentioned in this article.