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On Monday, President Obama submitted the fiscal 2013 U.S. budget proposal to the Congress. The lackluster budget of the election year carries plenty of reasons for deep furrows in defense primes.
The U.S. economic fundamentals are basically kept on a leash as the Euro-crisis continues to cast its spell over financial markets, keeping recessionary risks in the U.S. a real possibility, though the threat has abated somewhat in the recent past. Per the Bureau of Economic Analysis, in December 2011, personal income rose 0.5%, disposable personal income rose 0.4% and personal consumption expenditures witnessed a fall of 0.1%.
Obama envisions a Pentagon base budget of $525.4 billion, which is approximately $5.1 billion or 1% less than what is approved for fiscal 2012. However, what would darken the picture further for the defense primes is that the $525.4 billion is less by $45 billion versus what was projected for fiscal 2013, a year ago.
The amount allocated for U.S. wars abroad would also witness a sharp fall mainly owing to troop withdrawal from Iraq and a drawdown in Afghanistan. The Pentagon also shared details about $487 billion in spending cuts over the next 10 years to meet deficit reduction targets.
However, we must remember that in the current uncertain economy, bonds and high-dividend-paying stocks come foremost in the minds of investors. The average dividend yield of 1.9% for our actively tracked defense stocks is close to the S&P 500 yield, which is currently at 2.2%. The most prominent among these is Lockheed Martin Corporation (LMT - Analyst Report) with a yield hovering above the 4.5% mark. In contrast, the 10-year Treasury bond currently returns approximately 2.0%.
Lockheed, however, has a particular worry on the way the future of the F-35 Joint Strike Fighter is shaping up at the Hill. The downsized defense budget aims to wriggle out most of the savings from this program.
The budget proposal for fiscal 2013 suggests a deduction of $1.6 billion at one go from the F-35 program by eliminating 13 planned aircrafts. The budget proposal provides $9.17 billion for 29 F-35 aircrafts, two fewer than what were sanctioned for fiscal 2012. Proposals may also delay the procurement plan under the F-35 program, reducing its planned purchase order from 423 to 244 during the period between fiscals 2013 to 2017. The U.S. Defense Department estimates that this would bring in a total of $15.1 billion in savings.
Any cuts at the F-35 program would greatly affect the fortunes of the world’s largest stand-alone defense company, Lockheed Martin. The F-35 is the Pentagon’s biggest weapons program, at an estimated cost of $382 billion, for development and the purchase of planes. The scissor is at work on Lockheed’s Thaad missile interceptor program as well, which at a conservative estimate would bring in $1.8 billion in savings through 2017.
The downside on the F-35 program is bad news for another defense giant, Northrop Grumman Corporation (NOC - Analyst Report), which has substantial exposure to the program on account of its role as a subcontractor. The woes for Northrop would get bigger from the proposed $800 million cutbacks on the unmanned aerial vehicle Global Hawk program and the cancellation of the Defense Weather Satellite System. The Defense Weather Satellite System, estimated at approximately $2.3 billion through 2017, would be a huge blow for Northrop.
Further cost savings hurting defense primes is the proposed delay of the $1.3 billion U.S. Army’s new Ground Combat Vehicles program and delaying the development of the $600 million new ballistic missile submarine, the SSBN-X Future Follow-on Submarine program. The fate of the Ground Combat Vehicles program is uncertain in the near term, owing to the protest filed by Science Applications International Corporation (SAI - Snapshot Report) over not being awarded a technology development contract. The delay in the submarine program would not come as welcome news for General Dynamics Corporation (GD - Analyst Report) and Huntington Ingalls Industries Inc. (HII - Snapshot Report).
In an environment of cutbacks for defense primes, The Boeing Company (BA - Analyst Report) also could not escape the axe which came through lower purchases of the tilt-rotor aircraft, V-22 Osprey. Similarly Textron Inc. (TXT - Analyst Report) would be affected by lower purchases of Bell Helicopters.
Lastly, the 2013 budget proposal contains only $8 billion, 22% less year over year, for purchase and launch of Lockheed Martin and Boeing satellites.
Overall, in the past week, the Defense & Aerospace firms (we monitor actively) with an average beta of 0.9% rose 0.1%, on average, falling short of the performance of the S&P 500, which rose 0.6% over the same period. The miss, however, is primarily attributed to near-term market perturbations about the actual extent of cutbacks in the programs. Going forward, the aerospace & defense industry could be affected by a slew of job cuts on account of the number of deferrals, suspensions and reduction in defense programs.
Given the budgetary cuts and overall scenario it would not be too pessimistic to advise investors to adopt a wait-n-watch approach on defense and aerospace goliaths with a Zacks Rank #3 (Hold) over the near term. This includes players like Boeing, Embraer S.A. (ERJ - Analyst Report), General Dynamics, Lockheed Martin and Northrop Grumman.
Rare exceptions include Huntington Ingalls Industries with Zacks Rank #2 (Buy) on the strength of the $811 million inclusion to cover projected cost overruns on the Lincoln Carrier ship in the fiscal 2013 budget proposal.
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