Some the nation’s biggest defense contractors have reported better-than-expected quarterly results recently, helping to further boost share prices that have rocketed ahead much faster than the broader market this year.
The stocks of Boeing (NYSE: BA), Lockheed Martin (NYSE: LMT), Northrop Grumman (NYSE: NOC) and Raytheon (NYSE: RTN) have all gained between 43 and 73 percent this year, far outpacing the handsome 24 percent gain by the benchmark S&P 500 Index. Some analysts expect the defense stocks to surge even higher.
Though Wall Street investors may be heartened by those gains by defense contractors in the wake of the uncertainty caused by sequestration and the government shutdown this month, the industry itself is not entirely pleased.
“Some point to climbing stock values as a sign that sequestration has not harmed defense industry, but (the) industry is not as healthy as market prices suggest,” according to an Oct. 17 letter (PDF) sent to Congress by the National Defense Industries Association, a trade group. “For domestic defense business, share values have risen because of judicious workforce reductions, the repurchase of stock, and dividends paid to shareholders. These steps bolster a company’s short-term outlook at the expense of long-term investments. But industry has no other option.”
The industry has been put on the defensive because the dire warnings it issued about the impact of sequestration haven’t panned out. Todd Harrison, a defense analyst at the Center for Strategic and Budgetary Assessments, argued in the Washington Post in July that the industry “overhyped the immediacy of the sequester impacts, and I think that blew some if not all of their credibility.”
In an interview, Harrison noted that contractors put themselves in a bind by telling Wall Street that they can weather the effects of sequestration while at the same time arguing to Congress that the impact would be calamitous. “You just can’t have it both ways,” he said. “You need to pick a message and stick to it.”
Contractors did a better job in preparing for the sequester than the Pentagon did, according to Harrison. Lockheed, which makes the F-35 Joint Strike Fighter, is a case in point. The company has backed away from claims it made earlier this year that sequestration would wipe out $825 million in revenue.
Its latest results, though, were hardly robust, reinforcing the claims made in the industry group’s letter to Congress. The Bethesda, Maryland-based Lockheed did post a 16 percent gain in third quarter profit, but only one out of the company’s five divisions reported gains in both revenue and profit. The world’s largest defense contractor has slashed its workforce by more than 30,000 since 2008, as it braced for tighter Pentagon budgets. Earlier this month, it let go 600 people from its Mission Systems and Training Division.
Similarly, Boeing recently announced that it will end production of the C-17 transport plane in 2015, a project that employs about 3,000 workers. The company’s defense business reported a 19 percent decline in profit and a 3 percent increase in revenue in the quarter. In September, Northrop, which reported an 8.3 percent gain in profit, began a voluntary “reduction in force” program at its Aerospace business. Over the last five years, its “core workforce” has fallen 16 percent to 68,000. And Raytheon began 2013 with 3,000 fewer workers on its payroll than 2012. Over the last five years, its payroll has shrunk by about 5,000 workers. During the latest quarter, the world’s largest missile maker reported a 2.8 percent drop in profit from continuing operations.
Despite those cuts, one reason for the industry’s continued good fortune is that developing advanced weapons system can take years of advanced planning, which can be difficult to stop. These lead times cushion the impact of government spending cuts. “You get a lot of warning before a downturn actually hits the bottom line,” says Loren Thompson, an analyst with the Lexington Institute, who also is an industry consultant. The impacts of the cuts, he adds, are “taking a long time to unfold.”
Neil Dihora, a defense industry analyst at Morningstar, echoed those comments. “They heard the cries (to cut the budget) loud and clear and they cut expenses in front of them,” he said.
International business, which accounted for about 12 percent of total sales in 2012, may help buffer against some of the domestic cuts. Countries in the Middle East such as Saudi Arabia and Qatar continue to spend heavily. That trend will go on because of the conflict in Syria, according to a recent note by UBS. “It’s definitely been a cushion for all of the players,” Dihora said.
The F-35, the most expensive weapons system in history, also appears to be safe – at least for now – even though the Pentagon’s relationship with Lockheed, the prime contractor, has been rocky at times, Thompson, who consults for the company, said. “The Pentagon leaders say they are going to protect the F-35 from budget cuts,” he said. “I do not know if they will succeed.”
Still, the planned domestic cuts will be steep as the U.S. military adjusts to the end of wars in Iraq and Afghanistan and prepares for a changing mix of global threats. About $37 billion in sequestration cuts took effect in 2013 and the total U.S. defense budget has plummeted 21 percent from its 2010 peak, adjusted for inflation, according to the Center for Strategic and Budgetary Assessments. Unless Congress takes action, by 2021, Pentagon spending will have fallen by 33 percent in real terms.
“In comparison, the drawdown following the defense buildup of the 1980s slashed the defense budget by 35 percent, and the military reductions following the Vietnam and Korean wars decreased defense spending by 25 percent and 51 percent, respectively,” CSBA’s Harrison wrote in a recent blog post.
Absent a budget deal between the Obama administration and Republicans in Congress, the sequester will be here to stay. “The alternatives,” Harrison said, “are not panning out.”