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National Defense > Blog > Posts > Wall Street Still Unclear on When Defense Spending Will Hit Bottom
Wall Street Still Unclear on When Defense Spending Will Hit Bottom
By Sandra I. Erwin

Defense industry analysts have been perplexed in recent months by higher than expected outlays in the "modernization" portion of the military budget that funds research, development and procurement of weapon systems.

As of April, modernization outlays were running 17 percent below the high-water mark reached in 2010, but almost 10 percent above what the Pentagon projected to spend in fiscal year 2014 based on its budget authority. Total modernization spending for the year is down about 3 percent, a fraction of the 18.5 percent drop projected by the Defense Department.

Why this is happening and what it means for investors is a "big question on Wall Street," said analyst David Strauss, of UBS Investment Research. "Nobody knows what to make of it," he said. "People who are still positive on defense stocks think it's an error."

The Pentagon stands by its forecast. It attributes the discrepancy not to any accounting errors but to routine lag between outlays — payments made to liquidate obligations — and budget authority to incur those obligations. Outlays may lag budget authority by as much as 10 years, said Defense Department spokesman Cmdr. Bill Urban. Military and civilian pay obligations track closely with outlays and generally show up in the same year the budget authority was provided. But payments to contractors are a different story because the obligation may be made up to five years after the budget authority is provided, Urban said, and outlays may occur up to five years later.

Of concern to investors, however, is that budget authority for fiscal year 2014 is $155 billion for modernization accounts, whereas the outlay forecast is $148 billion. A $7 billion gap could mean bad news for contractors, regardless of when that low point is reached, Strauss noted.

Urban, the Pentagon spokesman, said 2014 outlays will stay above $148 billion, but he would not discuss projections beyond that. "As part of our 2015 budget proposal, the Defense Department estimated that outlays for our investment accounts would be approximately $148 billion, from 2014 and prior year funds, during fiscal year 2014," he said. The Pentagon does not provide revised outlay projections to the public before it releases the 2016 budget request, he said. "However, we estimate that at the end of fiscal year 2014, investment outlays will be above $148 billion."

The central question for investors is whether $148 billion is in fact the rock bottom number for modernization spending. "While we might not get to $148 billion by the end of fiscal 2014, is $148 billion the right level where we're going to go to? If so, how do outlays drop below budget authority level? And what causes that?" he asked.

One theory is that the Defense Department is borrowing unobligated balances from prior years to smooth over what's going on with sequestration, said Strauss. "That implies a pretty big hit," he added. "I don't know when we get to $148 billion, but if we do get there, that implies a major downsize from where we are today."

There are scenarios under which the Pentagon's dire investment outlay forecast could be correct, said Roman Schweitzer, defense industry analyst at Guggenheim Securities. Cuts to procurement spending in the overseas contingency operations war budget could be a factor. Another could be the automatic sequester cuts from fiscal year 2013, which likely forced the Pentagon to liquidate prior-year unobligated funds.

"Clearly something is off, but we’ve been unable to uncover the answer," said Schweitzer. It is possible that transfers or reprogramming could be reason for the disconnect. He noted that there are five months left in the fiscal year and outlay swings could still occur.

What frustrates investors is that many assumed 2014 was going to be the trough, and investment spending — based on the Obama administration’s five-year forecast — would begin to tick up in 2015, he said. "If the Pentagon's numbers are wrong, then it's unclear whether 2014 or 2015 is the bottom." The industry understands that outlay projections are estimates, and usually imprecise. But if investment spending does drop below budget authority, the implication could be that sequester is "flowing through the system" and that lean times will last longer than predicted. So far, top defense contractors have stuck to their projections of single-digit drop in revenues, said Schweitzer. "They don't show the huge drop the Pentagon is showing." So far, said Schweitzer, contractors have shrugged off the idea that a gigantic plunge in outlays would hit them this year.

But if the 2013 sequester is just starting to work itself into the system, investors will wonder whether the worst is over, or is there one more bad year in 2015? Schweitzer believes that if the data for 2014 is wrong, questions will be raised about the accuracy of the 2015 data. "Are we at the bottom now or will there be another drop next year because of some catch-up effect?"

Strauss said investors worry about the Pentagon forecasting modernization outlays that are $7 billion short of budget authority. Generally, the floor for outlays should be about equal to budget authority. "Defense companies are telling us revenues will decline 3 to 5 percent, and revenues generally track outlays," he said. If the bottom is $148 billion and the current spending rate is $170 billion, that implies a 13 percent revenue decline, Strauss added. "Whether it happens in one or two years, it's a deeper drop than what investors are anticipating.”

Adding to the uncertainty for investors is the possibility that Congress will stick to the Budget Control Act spending limits set for 2016 and beyond, and will reject the administration’s proposal to increase defense caps by $115 billion over the next five years.

“What will happen beyond fiscal year '14 and '15 once we get through this budget cycle on '15 and to '16 is we have an uncertain situation. That is when sequestration would come back into place unless Congress does something about that,” Lockheed Martin CEO Marillyn Hewson said May 29 at an investors conference.

Hewson said she remains optimistic. “We may still see some cuts in fiscal year '16 and beyond, but not at the sequestration level.”

Photo Credit: Thinkstock


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