Budget Battle Looms Over Subclass Military Stocks

By Matt Cavallaro | October 22, 2011 AAA

Spending cuts to the U.S. defense budget are a foregone conclusion, and $450 billion is already on the chopping block from this summer's debt ceiling deal. Big defense stocks aren't reflecting much of this macro risk premium. Surprised? You shouldn't be, considering one of the most effective lobbying groups in history is on their side. Will forthcoming federal spending cuts significantly impact defense stocks, or is the defense lobby in position to win another battle?

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Military-Industrial Complex
Automatic cuts to the defense budget, amounting to $500 billion beyond the approved $450 billion, could be triggered if the super committee can't come to an agreement by January for another $1.5 trillion in federal spending reductions over the next 10 years. Despite this possibility, big defense stocks like Lockheed Martin Corporation (NYSE:LMT), Raytheon Company (NYSE:RTN) and Northrop Grumman Corporation (NYSE:NOC) have rallied hard over the past month. The reason is pretty simple: there's little chance that this current crop of politicians picks a fight with the defense industry, in an election year no less, and wins.

Lobbyists are fully mobilized to protect their piece of the pie. The Aerospace Industries Association, a trade group representing some of the biggest U.S. defense contractors, released a report on October 25 citing the potential loss of one million jobs and $59.4 billion in wages if the automatic trigger goes into place. Never mind the economic consequences of spending way beyond your means, obviously. As the budget battle heats up in the coming months, don't expect anyone from Washington D.C. to look through "statistical studies" like these. (Are you a member of the armed forces? Check out Preparing Finances For Deployment: A Guide For Service Members.)

Under the Radar
Still, there will be some cuts and retail investors in subclass aerospace and defense stocks should be a little concerned. Smaller names in the industry have less ability to absorb the pain that is inevitably coming from a drawdown in defense spending. Companies like Esterline Technologies Corporation (NYSE:ESL), which has been pounded this year, is down 32% year-to-date. Esterline manufactures avionics, controls, sensors and systems for military and commercial purposes. Triumph Group (NYSE:TGI) is another under the radar defense stock that depends, in large part, upon government contracts obtained by big customers like The Boeing Company (NYSE:BA). Defense spending budget cuts will have a dramatic impact on both of these companies.

One company in this group really stands out and that is HEICO Corporation (NYSE:HEI), which is up 32% this year. Thanks to sales rising 25% in the fickle commercial aviation space, HEICO recorded a 37% increase in third quarter earnings compared to the same period last year. The outlook looks better for HEICO compared with competitors, but defense cuts, and a price-to-earnings multiple above 32, makes it one of the more expensive stocks.

Slowing, or receding, federal contract revenue growth is going to be something all defense companies will have to deal with in the coming years, and it could unequally impact those that the revenues trickle down to. Another disadvantage for these lower-tier aerospace and defense stocks is the paltry dividend stream. Triumph pays a diminutive 0.3% yield, HEICO's annual payout is 0.2% and Esterline doesn't offer one at all. That compares with Lockheed paying a 5% yield, Raytheon offering a 3.9% dividend and Northrop yielding 3.5% annually. Cash flows will likely become more volatile on fewer government contracts, and the market is going to want dependable revenue streams that only the big defense companies currently provide. (For more on dividends, read Why Dividends Matter.)

The Bottom Line
While it's likely that the defense budget cuts will be focused on operations and personnel, research and development and weapons programs are not expected to come under the knife. Moreover, it's hard to see legislators agreeing to a budget that slashes defense spending in any meaningful way. Politicians fighting the defense industry for spending cuts is a big mismatch like the Musketeers taking on the U.S. Marines.

Still, the numbers simply don't match up. The United States simply cannot continue on its current course, and defense is such a mammoth component of the budget. When additional cuts happen, and they will, the bulk is probably going to be back-loaded onto later years in any deal. Even aesthetic cuts and a flattening trajectory for U.S. defense spending will wear down defense stocks. The little guys could take the brunt of the damage.

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At the time of writing, Matt Cavallaro did not own shares in any of the companies mentioned in this article.

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