After years of increased defense spending in the U.S., the White House, Pentagon and Congress are now looking to cut military budgets. LIGNET believes investors can nonetheless realize healthy returns in the defense sector by focusing on high-dividend stocks that can still appreciate in value. Diversified companies such as Boeing (NYSE: BA) have robust defense acquisition programs and strong prospects for large arms sales to Gulf states due to tensions with Iran and thus are likely to be hurt less than others during this time of budgetary retrenchment.
Although it is possible that next year’s defense budget will not be finalized until early 2013, LIGNET believes that harsh budget cuts triggered by “sequestration” will probably be avoided in the end. The most likely scenario is that Congress will continue to use stopgap budget measures to fully fund the Pentagon until after the November election. Once it is determined which party will have the upper hand in the next Congress, it will be easier to negotiate a final deal.
The Pentagon’s 2013 budget has yet to be finalized, but is likely to follow one of three paths before it is finally resolved. The first possible outcome is the final passage of the Department of Defense Appropriation Act of 2013. This bill was approved by the U.S. Senate Committee on Appropriations at the end of July, but was not voted on by the entire Senate or House before legislators adjourned for summer recess.
If passed, this budget would come in at $605 billion—slightly lower than the White House request and $29 billion less than the current Pentagon spending level. Although this budget represents a large reduction, it is the best budget scenario for defense contractors.
Under its budgetary umbrella, many aircraft programs would remain untouched, including: transport and attack helicopters; the F-35 Lightning Joint Strike Fighter; the U.S. Navy Super Hornet fighter and Growler electronic warfare airplane; and a backup oxygen system for the U.S. Air Force’s F-22 Raptor. Procurement for several unmanned aerial systems will continue. Various attack missile and defensive missile programs will also maintain their current levels.
LIGNET does not think the Pentagon’s budget will be finalized before Election Day, but whichever party wins in November, they are likely to eventually push through a budget that is at or near the $605 billion spending level. If the Democratic Party does well in the election, the final number could be pushed lower.
In a worst case scenario, which would only occur if there was complete gridlock between Congress and the White House after the election, the defense budget would be automatically cut under the “sequestration” provision of the 2011 Budget Control Act.
LIGNET sees a much smaller chance of this scenario playing out, but if it does, defense contractors will likely endure significant financial hardship. These mandatory cuts made without any new votes in Congress, would slash the Pentagon’s budget by $500 billion over the next nine years—a reduction of around $55 billion per year.
Tensions with Iran could prove to be the salvation of U.S. defense firms in the event of truly painful U.S. defense cuts due to the enormous appetite by Persian Gulf states for U.S. military hardware. Gulf states like Saudi Arabia, Kuwait, and the UAE have spent more than $60 billion on advanced jet fighters, attack helicopters, and missile defense systems since 2010. Companies that can produce and/or support these systems are likely to continue to see brisk sales.
With the political season reaching its peak, it is likely the tug-of-war between the $605 billion defense budget and the harsher “sequestration” alternative will remain stalemated until after election day, and perhaps even through the lame duck session before the next Congress begins.
During this interregnum, Congress will continue to use “stopgap” budget measures to keep the Pentagon fully funded. It is possible this third outcome could continue well into 2013, with the chances for a final defense budget depending very much on the outcome of the November election.
LIGNET believes all of these budgetary paths bring with them uncertainty and volatility for the defense stock sector, but there are a few companies that should be more insulated from the Pentagon budget cuts than others.
Stock Selection Method
Defense stocks recommended by LIGNET were initially screened based on price and dividend yield. Five additional stock picking criteria, borrowed from author Phil Town’s investment strategy, focus on growth metrics relating to return on investment, earnings, sales, book value and cash flow. Town’s“Big Five” fundamentals are explained in more detail below.
· Return on Invested Capital (ROIC) is an excellent gauge on how well a company and its management team uses the money invested in its business activities. Based on percentage returned on capital investment, ROIC should grow above 10 percent a year if the company is dominating its sector.
· Earnings per Share Growth should be in double-digits annually if a company’s bottom line is healthy.
· Sales Growth should also be in double-digits over the prior 12 months if a company is consistently growing its revenue from sales.
· Book Value per Share Growth is a little more complex as it shows a snapshot of a firm’s value. Also called “equity growth,” it measures how strong a company is in terms of the surplus left over if it had to completely sell every asset it owns. Book value per share can explain whether a company has an adequate safety net or “moat” around it — what Warren Buffet calls “intrinsic value.” This metric should grow at least 10 percent a year.
· Cash Flow Growth should also be in double-digits each year. This metric uses cash from operating activities on each company’s sales and revenue.
- Three Things Every American Needs To Know About Defense Cuts (businessinsider.com)
- Even If Transparent, Sequestration Still a Bad Policy (heritage.org)