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Warning! Defense Stocks Are Under Attack!

Or are they? Chances are deep Pentagon cuts won't ever happen


The whole concept of the congressional budget supercommittee was flawed from the start.  It should not have taken this ridiculous plan to do what Congress should have done on its own — cut spending. I’m not saying this to be political. I’m saying it because as a result of our political leaders’ failure to do what they should have done, it creates uncertainty in the markets. In this case, it creates particular uncertainty in the defense sector.

The supercommittee’s failure requires that $1.2 trillion be cut from the federal budget over the next 10 years, of which $600 billion is mandated to come from defense spending. The questions are: Where will those cuts hit, and will they affect any stocks? And adding to the uncertainty is another question: Will the cuts even come at all?

Assuming they do, it’s almost impossible to know what programs will get cut. Some are pet projects for individual politicians, and the defense sector contributes to both sides of the aisle. My own military sources suggested the following programs could be in danger. The first is Raytheon (NYSE:RTN)’s Patriot missile system. Next up is Lockheed Martin (NYSE:LMT) and Northrop Grumman (NYSE:NOC), which are partnered on the F-35 warplane development.

There’s a plan to upgrade the Abrams tanks at General Dynamics (NYSE:GD). But tanks aren’t high on the Pentagon’s importance list because they imply ground warfare, which nobody is anxious to get involved in. Of course, my sources say the actual Pentagon itself should be gutted because it’s obsolete, mired in bureaucracy and ineffective.

If you want to hedge your bets against the entire sector, you could always short the PowerShares Aerospace and Defense (NYSEARCA:PPA) and iShares Dow Jones Aerospace and Defense (NYSEARCA:ITA). Beyond that, the market appears to have discounted Northrop by 10% already.  The rest of the stocks are not off much at all. So let’s be super-conservative and suggest each company losing as much as $30 billion in revenue.

Along with that revenue, however, will go expenses. Lockheed’s net margins are 6.32%, so figure bottom-line impact of negative $190 million, or 6 cents per share to $7.79 in 2012, which is only 7.5% of net income. Sounds like a lot, but it’s not much at all in the grand scheme of things.

For Northrop, the impact is $168 million of net income, sending earnings from $6.84 per share to $6.78 in 2012, down 3% year-over-year. Big deal. Raytheon? A 6 cents-per-share drop, giving the company net earnings of $5.16 in 2012, still up from $5.04 in 2011, for a 3% YOY increase. General Dynamics earnings would get hit the most, dropping $315 million, or 9 cents a share, sending net income down to $7.49 in 2012, still up 4% YOY. So overall, the net impact across these companies isn’t going to be terribly significant in my view.

More to the point, however, I don’t actually believe the cuts will ever happen. Congress doesn’t cut spending.  It increases spending. It always does.  I think any concern is overblown, and that’s why I wouldn’t change a darn thing in my portfolio if I held defense stocks. Investors who are particularly paranoid may want to consider shorting the ETFs above in some small amount as a hedge.

Lawrence Meyers has no position in any security mentioned.

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