Defense Industry Outlook – Looking Past The Headlines

Defense industry outlook – Looking past the headlines by ColumbiaManagement

Ben Blomberg, Senior Equity Analyst | March 17, 2014

Defense investors have had their share of bad news around the trajectory of defense spending, starting with the Budget Control Act of 2011, followed by the failure of the congressional Super Committee to reach an agreement, leading to the onset of sequestration in March 2013. But ever since negative headlines peaked in early 2013, the outlook for large defense contractors has improved, particularly for those with little exposure to the U.S. Army.

Army spending under pressure

The most intense pressure over the past four years has been on contractors supplying hardware or services tied directly to war efforts in Iraq and Afghanistan, and spending will likely continue to decline in coming years. But Navy and Air Force base budget spending has been much more stable (the last major program cancelations took place in April 2009) and likely will continue to be well supported, as evidenced by the FY14 (fiscal year 2014) FYDP (future year defense plan) that accompanied the FY14 government “Green Book” as a result of the Department of Defense (DoD) pivoting to Asia (see Exhibit 1).

While Army spending remains under pressure due to a declining base budget and headwinds from conflict-related supplementals, the defense build-up between 2003 and 2009 had almost exclusively benefitted the Army. However, the last major investment cycle for the Navy and Air Force ended in the late 1980s when the Cold War came to an end — the average age of Air Force planes and Navy ships is approaching record levels. Despite the specter of sequestration putting stress on many smaller programs, the services have been very keen to protect previously agreed upon fixed-price contracts on the new KC-46 tanker and F/A-18 fighter aircraft.

Exhibit 1: Procurement by service ($B)

Source: DoD

Exhibit 2: Long-term DoD budget outlook

Sources: Citi, DoD

Improved near-term outlook for defense spending

The near-term outlook for defense spending has improved under the December 2013 Ryan-Murray bipartisan budget act (Exhibit 2). Budget decisions over the past few years have tended to cut monies from the outlook through FY22, but the exhibit shows how the recent Ryan-Murray deal added $14 billion to the FY14 defense budget and about $5 billion to FY15. Despite the raised floor for FY14 and FY15, sequestration remains the law of the land for FY16 and beyond. From observing the political process around defense spending and feedback from defense contractors, it appears that the debate has become more civilized, implying a more predictable, slowly growing budget from here. Importantly, there appears very limited political appetite to make further substantial cuts to the base budget, with headline overseas contingency operations (OCO) spending tied to the efforts in Iraq and Afghanistan the only major headwind. Note that OCO spending has fallen from a peak of $187 billion in 2008 to $87 billion in 2013, with likely substantial additional declines. But OCO exposure for most large prime contractors is nominal at this point, with a very limited impact to future earnings and cash flows.

Management teams in the industry cried wolf after the Congressional Super Committee failed to reach an agreement in the fall of 2011, with executives worried about a hollowing out of the defense industrial base if sequestration reduced budgets by another 10%. The threat of sequestration has allowed contractors to aggressively slash cost, which has led to impressive margin performance over the past 12 to18 months despite top line declines that averaged mid-single digits for most long-cycle companies. For non-Army exposed contractors, we are likely past the steepest decline in revenue, with a bottom possible in either 2014 or 2015.

Investment accounts see growth in FY16

Within the defense budget, we see some positive trends for contractors: Procurement should outgrow R&D spending, which supports margins as contractors generally earn more on mature procurement programs versus development contracts. But the overall investment account should also outgrow the defense budget as modernization grows at the expense of a smaller force: Pentagon leadership wants a smaller, yet technologically superior force. Army end strength will likely decline from a current 520,000 force to 440,000-450,000 by 2017, freeing up monies for investment. It takes time to ramp down manpower, so the initial hit during a budget downturn tends to be on procurement and readiness, as seen over the past few years.

Exhibit 3 highlights the percentage of the base budget that is allocated to investment accounts over time. The differently colored bars indicate progression over time with the dark red bar corresponding to the FY12 President’s budget request made in early 2011. The exhibit shows the bottom for the investment accounts, which is relevant for contractors, is reached in FY15 based on the most recent FY15 request, with growth in FY16 and beyond.

Exhibit 3: Investment account as a % of base budget

Sources: Citi, DoD

Pension tailwinds are another major positive, providing a likely tailwind for companies’ earnings and cash flow through at least 2017: When interest rates declined sharply in 2008, the funded status of contractors’ pension plans plunged. Consequently, companies spent a substantial proportion of their cash flow to prop up underfunded plans. But U.S.-based defense contractors are unique in that the government will ultimately reimburse companies for their pension outlays, with major tailwinds based on government pension accounting between now and 2017, compounded by higher pension discount rates. Note that these tailwinds are not just accounting tailwinds, but entail real cash flows.

Despite the negative headlines, the outlook for defense contractors is fairly robust, with a more positive budget outlook compounded by pension tailwinds over the next four years. The main caveat would be valuation, which for the average stock has become much more “normal” over the past year at a current 5%-10% discount to the S&P 500 on pension-adjusted earnings after spending much of the prior four years at a 35%-40% discount.