By Sandra I. Erwin
There is a strong chance that Congress will defer or repeal $500 billion in defense budget cuts that by law must take effect in January, analysts predict. But the mere possibility of this happening already has had a chilling effect on industry mergers, acquisitions and industry stock valuations, said Jeremy W. Devaney, vice president and senior equity analyst at BB&T Capital Markets defense and aerospace sector.
Defense prime contractors collectively had been outperforming the S&P 500 stock index for the past 18 months, he said. The gap has narrowed of late, and now defense stocks are barely trading ahead of the S&P 500, Devaney said. The threat of automatic budget cuts, or sequestration, that Congress enacted last year in a deficit reduction deal are part of the reason for the declining market performance, he said. Over the summer, the outlook could worsen once it becomes clear that Congress won’t move forward with any compromises to avoid sequestration until after the November elections, Devaney added. “We think sequestration is not fully baked in.”
Revenues across the industry have declined more as a result of the uncertain spending forecast than because of actual cuts, he said. Pentagon program managers are delaying awards at least until the sequestration scenario is resolved. That has prompted prime contractors to take emergency actions to boost their bottom line, Devaney said. That means using cash reserves to offset the slowdown in revenue, in the form of stock buybacks and dividend increases. “That might not be sustainable,” he said.
The business paralysis also is seen in mergers and acquisitions. Industry consolidations in the government contracting sector had been expected to rise in response to budget cutbacks, but Washington gridlock has trumped that trend.
“Companies are protecting cash flows, not making investments,” said Devaney. Corporations that have money are sitting on their hands and waiting, he said. “That’s echoed across all levels of industry.” The stagnation should continue “until they understand where the customer is investing,” Devaney said.
Corporate acquisitions are still being pursued on the commercial side as defense suppliers seek to diversify their businesses, he said. “They look for adjacencies they can move into.”
The slowdown in corporate mergers is occurring as Defense Department officials hint that consolidation will be necessary to downsize an industry with excess capacity. In a May 30 speech at the American Enterprise Institute, Deputy Defense Secretary Ashton B. Carter, said the Pentagon’s position is that market forces should drive the consolidation, as opposed to the government picking winners and losers. In what appears to be contradictory policies, Carter also said the Defense Department will seek to prop up what it considers key sectors of the industrial base.
“We believe that the DoD is now coming to terms with the idea that industry consolidation of the supply chain may need to occur as a result of the budgetary pressure,” said Devaney. “We are intrigued that the DoD may seek to provide sustainment funding for certain industrial base functions that are at risk of extinction as certain programs are stretched or take a hiatus.”
Any conceivable long-term plan, however, will be fruitless until the current legislative gridlock is untangled, he added. “Between a probable CR [continuing resolution for fiscal year 2012 spending], a presidential election, congressional elections, lame duck session, and sequestration, the vast majority of catalysts we can see in Defense appear to be negative, which continues to erode investor sentiment in the defense sector,” Devaney said. “Until psychology and visibility within defense improves, we believe investment upside potential in the sector may be limited.”
Beltway insiders, meanwhile, predict more pain for the defense industry. Former Deputy Defense Secretary John Hamre, wrote in a recent Center for Strategic and International Studies white paper that “deeper defense cuts are inevitable.”
If the nation stays on the current trajectory — with entitlements and taxes off the table — the defense budget will decline by $1 trillion over 10 years, including the $487 billion cut already submitted, he said. “If both parties agree to a grand compromise with cuts ranging from $4 trillion to 5 trillion, defense’s ‘fair share’ will be about $1 trillion. But at least then we will have solved the great peril to our society, even if it means fewer resources going to defense in the near term.”