Defense Stocks: The Great Guns vs Butter Stocks Debate

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By: Margin of Safety Equity Research.

Most of us who managed to stay awake in our high school history class are familiar with the “guns and butter” debate that dominated American politics back in the 1960’s. It was a time when our country was mired in the upheavals of an unpopular foreign war and calls for more social programs to aid the poor and the elderly. Our politicians were tasked with finding ways of funding both. Out of that sprung the Great Society programs which included Medicare and Medicaid and an escalation of the war inVietnam, both of which required massive new spending. The same guns and butter debate rages on today, however, this time, it’s is not centered on how the country can pay for both; rather it pits one against the other where one party wants to see cuts in defense in order to pay for butter programs like health care reform and other domestic social programs. For investors, the results of this debate can have a long-term impact on stocks in the defense and food industries.


The Outlook on Defense Stocks

While the politicians wage a battle to determine the right balance of guns (defense) and butter (domestic programs) to carry our nation forward, investors are waging a battle against the uncertainty that has enveloped the market over the spending stalemate in Congress. With the possibility, of automatic $600 billion budget cut in defense spending, whole sectors of the economy related to defense goods and services are perching on a wobbly fence wondering which way the wind will blow.  Although few people expect the worst case scenario to actually occur, defense contractors are expecting additional spending cuts, but the question is how deep will they go?

The sector has been under increasing pressure anyway as the wars in Iraq and Afghanistan wind down, and cuts in military spending have become a foregone conclusion after the $350 billion, ten year reduction in the defense budget was negotiated in the deficit ceiling resolution.  Defense contractors that rely heavily on revenue from government contracts have been under the most pressure, while companies that have broadened their revenues sources or that focus on non-combat goods and services are more even keel but still feeling the heat. Here’s a sampling of how companies with varying levels of government contract exposure and product diversification might fare under the new budget reality:

Lockheed Martin (LMT):  With some estimates that as much 50% of the budget cuts centered on weapons programs, Lockheed could be especially hard hit. The cancellation of the $385 billion F-35 fighter jet would eliminate 40% of its profits which were realized in the first 6 months of this year. Lockheed generates more than 60% of its revenues from military contracts. Lockheed could also lose its contract for two combat vehicle projects worth $40 billion. The company let 6,500 employees go over the summer in the face of a 5% decline in its share price.

Raytheon (RTN): A recent industry analysis by Credit Suisse lists Raytheon among the defense contractors that should fare better than the rest of the industry largely due to its diversified product line and low reliance upon supplemental war budgets. The company generates 25% of its revenues from foreign contracts where the margins are higher and growth is expected to continue, and it is also involved in top secret contracts which should remain intact. Its revenue is even further diversified among 8,000 different programs, so a cut in any one of them will have a minimal effect.  Its multiple has been slashed nearly in half to about 9 which, when investors realize it won’t be hurt nearly as hard by cuts, may serve as a catalyst.  With a current 3.5% dividend yield, it can carry patient investors through the budget cuts.

Boeing (BA): Credit Suisse also pegged Boeing as one that is better positioned stocks to weather the budget cutting storm. With substantial revenues coming from  the commercial jetliner business, the company projects further growth there over the 30% profit increase it reported this year. It is encouraged by demand for its new 787 Dreamliner and its growing backlog of 737s. The company has been on a project restructuring tear to cut back in threatened projects while expanding in areas that could actually see revenue growth from defense procurement. Buoyed by strong third quarter earnings, strong balance sheet and its positive outlook for its commercial liner segment, the company recently boosted its dividend by 5% to $1.76.



How will “Butter” Stocks Fare in the Guns and Butter Debate

One of the by-products of the massive “butter” spending that has occurred over the last several years is a sudden spike in food inflation.  With our national debt at atmospheric heights, and government borrowing driving the value of the dollar even lower, the resultant spike in import prices has found its way onto our grocery shelves.  Normally, investors were able to fight food inflation with food inflation. In other words, they could get on the defensive by buying food company stocks that typically perform well during all economic cycles because of their pricing power. But, when commodity prices increase quickly, the input costs can force a faster increase in food prices. At some point, consumers aren’t going to pay the price and will revert to generic brands or forego snacks all together.

Companies like Kellogg (K) and General Mills (GM) have been experiencing a decline in profits on higher sales due primarily to increased input costs. Sales increases are offset to varying degrees in a falloff in volume. When the price of Cheerios creeps up over $4, suddenly the “toasted oats” store brand doesn’t taste so bad. The company said that this has been the “highest level of [food] inflation the company has seen in recent years.” It expects that it will become increasingly difficult to offset rising costs from price increases before they see a significant drop in volume.

Kraft (KFT) is experiencing the same issues; however, it has done a little better job in shielding consumers from increasing input costs. In addition to cutting packaging costs, it has also adjusted serving sizes (i.e. reducing number of cheese slices in a package). It has managed to post strong earnings this year while absorbing more than $1.5 billion of commodity cost increases.  It is spending more on advertising and adding more new products to market to offset the loss of volume in some of its higher priced product lines. Kraft is also planning to spin its international snack business off from its domestic grocery business which should unlock shareholder value in each of them.

In normal economic cycles, defense stocks and food company stocks have been solid defensive plays. But that was when defense budgets went no place but up, and food companies had the power of pricing at their disposal. That’s not to say that, selectively, they can’t still protect a portfolio. All of the stocks mentioned here pay a solid dividend, and all of them will weather the uncertainty of near term fiscal policies and macro-economic pressures as they have so often in the past. In sum, investors should be aware of the macroeconomic consequences of the guns vs. butter debate.

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