By Dag Potter
Published: 21 August 2011
Most of the large and mid-sized defense contractors reported their most recent quarterly results in the last few weeks. While for the quarter the results were mixed with some seeing decent increases in earnings and revenue while others saw a drop overall they all felt that they would meet or exceed their estimates for the full year. The 2011 defense budget still remained high due to the extra spending for Afghanistan and Iraq as well as investment in some major weapon systems. The 2012 budget is working its way through Congress and will see some reductions based on proposals by the Services as well as Congress’ directed cuts but overall will be about the same as 2011. Spending beyond that could be considerably reduced based on the new debt reduction “super committee” as well as the pressure to decrease overall Federal deficits.
As the focus of the defense budget changes from paying for the troops in Afghanistan and Iraq and the equipment and supplies they need to invest in new systems to replace older one or achieve new technologies some defense contractors will prosper over others. If the discussed defense cuts are followed through and amounts vary from $35 billion to $70 billion a year from a $700 billion budget then some major programs will be canceled, the size of the military will decrease greatly and parts of the defense industry in the U.S. will disappear. This will either be through M&A activity or just loss of contracts causing companies to fold up.
There have already been moves by the larger defense contractors to adjust to the potential changes in how the U.S. Defense Department spends its money. ITT Corporation (ITT) has decided to split yet again into three different companies basically separating their flat performing defense business from more successful water and chip manufacturing areas. (http://technorati.com/business/finance/article/itt-continues-to-make-money-off1/) L-3 Communications Holding (L3) while it had a good quarter announced that it too was spinning off part of itself to adjust to what it sees as the future in the U.S. It is setting up its Scientific, Engineering, Technical and Analytical (SETA) business as a new company. SETA contractors support government offices most often in acquisition and research and development. Many of these positions were converted to government positions and new Organizational Conflict of Interest (OCI) rules prevent companies that provide SETA services to also bid on large hardware programs. L-3 is adjusting by getting out of the business.
Perhaps the biggest adjustment was by Northrop Grumman (NOC) who moved to separate their entire shipbuilding segment earlier this year. Rather then sell it to one of their competitors they set up a new company entirely, Huntington Ingalls Industries (HII). This was in realization that future U.S. Navy shipbuilding plans were so limited it could not necessarily support the current number of shipyards in the U.S. HII has already moved to close its yard in Louisiana with significant effect on the local economy.
Other companies have moved out to use M&A to position themselves. Many of the larger companies such as Boeing (BA) and Lockheed Martin (LMT) have been buying intelligence and cyber security companies to expand their opportunities. General Dynamics (GD) earlier this week made a big move by spending almost $1 billion on a health IT company. With the focus on health care reform including improvements in record keeping and storage IT may become a big source of business for government contractors. The company, Vangent, which was privately held also just completed a large contract with the Census Bureau that should be offered again in a few years.
The U.S. military is pursuing some large programs over the next decade. These if they are canceled or cut back will have the largest effect on revenues and earnings. For Lockheed Martin it is the F-35 Joint Strike Fighter that is finally moving towards large scale production. A reduction in planned quantities will severely affect that company. For Boeing it is the KC-46A new aerial tanker as the Air Force plans to buy at least 179 initially at a cost of over $30 billion. General Dynamics has major ship and submarine construction programs and the Navy if it cuts these will limit GD’s future performance.
Right now the next several months should see major defense contractors maintain their revenues and earnings except in odd cases where contracts are restructured or ending. Once the 2012 budget is decided upon that will give an indication of how next year will be. Then 2013 and out should start to see some cuts in defense spending with similar effect on the companies. It can be expected that there will be a decrease in performance accelerating if severe cuts are made by the United States. The ability of the contractors to move to different business areas in response to these cuts will dictate how badly they are affected. All indications are right now that this sector will struggle in the next few years to maintain what they have let alone growing it even more. There may be more moves coming similar to those by Northrop, ITT and L-3.