Fiscal Cliff Puts Defense Stocks Under the Gun

Fiscal Cliff Puts Defense Stocks Under the Gun

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The "fiscal cliff" is one of those phrases that has become all-too familiar in recent months, as economists and other pundits agonize about what might follow a failure by Congress to do something about tax cuts enacted in 2001 and 2003 scheduled to expire on New Year’s Eve, and $1.2 trillion in budget cuts that will begin to take effect that same day, automatically.

Wrangling over how to address the fiscal cliff hits pretty much every hot button on both sides of the aisle in Congress. What should government spend its resources on – health care or defense? Should Congress raise taxes on the country’s wealthiest citizens – or lower them? No wonder that our elected politicians seem as far away as ever from agreeing on what to do to come to grips with the consequences of the Budget Control Act of 2011, which mandated future spending cuts as the price of raising the U.S. government’s debt ceiling.

The nonpartisan Congressional Budget Office has warned that a failure to act in what is likely to be a short legislative session between the early November elections and the end of the year could spell disaster, pushing the economy back into recession. Certainly, economists seem to agree that the result would be a $600 billion drag on the economy next year.

Now Morningstar has again reminded us of the potential impact of these cuts on the defense industry – and investors who own the sector. Defense has been clearly identified as a target for spending cuts – $500 billion of that $1.2 trillion – and companies have been scrambling to reinvent themselves or prepare for what might lie ahead, even as they try to whip up the pressure on legislators.

RELATED: OMB: Sequestration Could Cut Defense by 9.4%

Lockheed Martin (LMT), for instance, has warned that it could be forced to lay off half or more of its 100,000 employees if mandatory spending cuts go through; certainly, most defense contractors already are looking for ways to trim their workforce. That’s hardly helpful at a time when the Fed has ventured into unexplored waters in hopes of reducing the still unacceptably high unemployment rate.

Morningstar’s analyst, Neal Dihora, warned in a note published yesterday that in spite of the threat of these large-scale cutbacks in military spending, which has been looming overhead for more than a year, the low valuations of many large defense stocks still don’t reflect the full potential impact of the fiscal cliff. “We remain concerned that should Congress fail to avert the upcoming cuts, the businesses will suffer sales and operating profit declines,” he noted.

Sure, most of these stocks boast appealing dividend yields and tempting valuations – Lockheed Martin, for instance, boasts a hefty 4.34 percent yield, while trading at merely 10.8 times trailing 12-month earnings – but in the event of Congressional inaction, the question becomes how safe those dividends would look and whether the earnings underlying those valuations can be sustained.

Defense contractors aren’t sitting idly by, of course. "We will acquire, we will divest, we will reshape, we will re-portfolio as we need to,” Jay Johnson, the CEO of General Dynamics (GD), is reported to have told a conference last week. The company has put its money where its mouth is, spending $360 million in cash to acquire Force Protection Inc. (FRPT), a South Carolina business that makes armored vehicles designed to protect occupants from land mines, and more recently agreeing to purchase Fidelis Security Systems, a cybersecurity company.

General Dynamics – which trades at an even lower valuation than Lockheed Martin, 9.64 times trailing earnings, and offers at 3.07 percent yield – is seen as one of the most heavily exposed to spending cutbacks, given that is business is most likely to be hit by the withdrawal of U.S. forces from both Iraq and Afghanistan. It already is seeing its earnings slump; its second quarter profits slid 2.9 percent and the company trimmed its earnings forecast for the fiscal year as its largest business division – information systems and technology – reported a 10 percent drop in revenue and a 24 percent plunge in operating earnings.

Investors who own defense stocks may want to brace themselves for more such blows from companies like General Dynamics, Northrop Grumman (NOC) and Lockheed Martin, all of which generated more than 20 percent of their earnings from information technology services to the military. These, Morningstar’s Dihora argues, “are more negatively affected (by cutbacks) than long-cycle businesses such as shipbuilding or aircraft acquisition. In periods of budgetary inconsistencies, purchasers have limited ability to procure services for fear of lack of funds, and they begin to prioritize projects.”

Few members of Congress will want to be seen as starving the country’s national defense programs of the resources they require, particularly as geopolitical tensions in the Middle East and Iran remain at such a high level. So far, however, that doesn’t seem to have helped them reach any kind of agreement on how to implement budget cuts in such a way as to avoid the kind of mandatory, across-the-board cuts referred to as “sequestration” that would be the consequence of toppling over the fiscal cliff.

What is very possible is that Congress will reach a last-ditch agreement to push that deadline further out. Don’t take that as a signal to jump back into discount-priced defense stocks, however. Uncertainty – commonly referred to in the markets as a “lack of visibility” – is a deadly enemy at the best of times, and simply postponing the ferocious (albeit bloodless) Congressional battles over the budget won’t resolve that uncertainty for defense companies and their investors. And however skillful management teams have been at preparing for budgetary Armageddon – whether they are cutting back or, like General Dynamics, making strategic acquisitions – the benefits of these strategies won’t pay off rapidly enough to offset the shock of the forced cuts.

The good news – and there is some of it out there, albeit in the dim and distant future – is that if Congress miraculously manages to reach an accord on how budget cuts will take place, eventually the current panic may well end up pushing many of the largest defense contractors into becoming more streamlined and efficient businesses – and thus more appealing investments. But this is the wrong time to be hunting for bargains in the group based on that kind of optimistic assessment of the future. Defense stocks right now demand that investors take a more, well, defensive position.