This time last year, the word “sequestration” had defense companies and their shareholders waiting for the sky to fall and crush earnings. But as it turned out, defense contractors not only weathered that storm, they even boosted profits.
That was last year, however, and it could be tougher for defense stocks to emerge from the next round of automatic budget cuts unscathed if Congress doesn’t act to repeal them.
The Pentagon sounded the alarm on Tuesday that sequestration cuts for weapon systems are set to kick in between fiscal 2016 and 2019; those cuts could gut military readiness and have grave implications for national security:
“With the addition of projected sequestration-level cuts for FY 2016 through 2021, reductions to planned defense spending for the ten-year period from FY 2012 to 2021 will exceed $1 trillion. If sequestration-level cuts persist, our forces will assume substantial additional risks in certain missions and will continue to face significant readiness and modernization challenges. These impacts would leave our military unbalanced and eventually too small to meet the needs of our strategy fully.”
If Congress fails to repeal sequestration cuts that will automatically take effect between FY 2016 and FY 2019, these five major defense stocks stand to take a significant hit:
Lockheed Martin (LMT)
Lockheed Martin (LMT) — the largest defense pure-play — managed to overcome sequestration and sagging Pentagon spending the last time around, posting earnings per share of $9.58 for 2013 on a top line of $45.4 billion. LMT’s profitability last year was driven by aggressive moves to moves to cut overhead costs. But this time around, the Pentagon’s top contractor might not be so fortunate.
In order to reach sequestration spending levels, DOD will have to cut 17 F-Lightning II Joint Strike Fighters, which cost between $153 million and $200 million each. Fifteen of the fighters are conventional F-35As; two are F-35Cs that are modified for aircraft carrier landings.
General Dynamics (GD)
General Dynamics (GD) ended 2013 with an EPS of $7.03 on a top line of $31.2 billion, thanks to a combination of frugality and blockbuster performance in its Gulfstream commercial aircraft business. The new sequestration poses a significant threat to Pentagon shipbuilding contracts, some of which are shared with Huntington Ingalls Industries (HII).
The report reveals sequestration could result in one less Virginia Class attack submarine and three fewer advanced Arleigh Burke DDG-51 destroyers. While that doesn’t seem like much, those four naval vessels account for more than $3 billion. Additionally, GD would lose out on $681 million worth of Stryker double-v hull armored vehicles.
In 2013, Raytheon (RTN) reported EPS of $6.38 on $23.7 billion in revenue. The company, which derives most of its revenue from military products like the Tomahawk Land Attack Missile and the Patriot Surface-to-Air Missile, also has been focused on cutting costs.
The company’s investors were pleased by RTN’s large-scale stock repurchases last year. Despite lower U.S. defense spending, RTN is growing international sales for its integrated defense and missile systems. Nevertheless, the Pentagon says it will have to cut 531 of GD’s Advanced Medium-Range Air-to-Air missiles if Congress lets sequestration stand.
Northrop Grumman (NOC)
Northrop Grumman (NOC) ended 2013 with earnings of $8.35 per share on $24.7 billion in revenue. NOC, whose key defense programs include its rock star Global Hawk unmanned drone, E2-D Hawkeye surveillance aircraft and high-test cybersecurity solutions, also cut costs aggressively last year.
While conventional wisdom suggests that DOD would rely more on unmanned aircraft in tight budget times, that’s not the outcome the Pentagon report envisions. In fact, the cuts call for DOD to divest the Global Hawk Block 40 fleet of advanced drones. Privately held General Atomics’ Predator drone also would be phased out by 2016, the report said. If the Pentagon’s drone purchases crash, it could have a big impact on NOC, which is struggling with volatile earnings recently.
Despite a wild year that saw defense cuts and Boeing’s (BA) flagship 787 Dreamliner grounded for months, Boeing survived the turbulence well: earnings for 2013 were $7.07 per share on revenue of $86.6 billion.
Although defense cuts slightly hit the company’s revenue, Boeing has managed to grow margins and market share, while managing costs effectively — and commercial aircraft sales remain white-hot. Still, the Pentagon says it will have to axe 67 Apache helicopters and five KC-46A tankers if sequestration can’t be derailed — and that could hurt margins and earnings for BA stock.
Defense stocks have had an amazing run over the past year despite the Pentagon’s extreme belt tightening. Companies like LMT, GD, NOC, BA and RTN have aggressively cut costs, boosted sales to international buyers and taken advantage of powerful non-defense business lines. Because of this, defense stocks have rewarded shareholders with strong performance and attractive dividends.
That said, these defense stocks are trading near their 52-week highs, and from a valuation perspective, none of them look like bargains now. If you’re already in these defense stocks there’s no reason to panic — these are still strong stocks, and the dividend income further sweetens the pot. But now is not the best time to get into any of these defense stocks, as there is likely to be a pullback in the near future.
As of this writing, Susan J. Aluise did not hold a position in any of the aforementioned securities.