Defense Stocks May Lose Safe-Haven Status In Budget Review
27 February 2009 - 7:50AM
Dow Jones News
When President Barack Obama quipped this week that he was happy
to inherit used Marine One helicopters, the remark did more than
cast a cloud over a $9 billion contract to replace the aircraft
fleet.
The rise in defense spending during the Bush years had made the
sector a safe haven for investors, but the new administration and
influential lawmakers already are pointing to new priorities and
procurement practices that could challenge that status.
The Spade Defense Index of about 50 stocks has outperformed the
S&P 500 over the past eight years, though it just squeaked
ahead in 2008.
Scott Sacknoff, who manages the index, doesn't expect much
near-term impact from the changes in Washington D.C., as the U.S.
still must replace equipment on its multiple battle fronts
overseas.
Bill Swanson, chairman and chief executive of Raytheon Co. (RTN)
told analysts earlier this month that he expects the awarding of
new contracts this year to go smoothly. With Secretary Robert Gates
continuing in the top defense post, and most of the new
administration's team in place, "this transition is as smooth as
I've seen," he said.
The Obama administration's five-year plan, expected later this
year, will provide clearer guidance as to what might change.
"The important figure to look at is research and development,
plus procurement," Sacknoff said of a figure now around $175
billion, out of a total budget of more than $5 billion. "That's the
money that goes to companies."
Obama already has signaled some broad changes, including an end
to no-bid contracts, "Cold War-era weapons systems" and a Marine
One replacement program he described as "procurement gone
amok".
Gates is expected to flesh out the details of the President's
plans, although an exact date hasn't been set. Gates has backed a
"75% solution" rather than 100% upgrades to existing programs,
cutting back on expensive technology that may not be fully
operative for years.
Congress Gets Serious About Defense Cuts
Sen. Carl Levin, D-Mich., chairman of the Senate Armed Services
Committee, and Sen. John McCain, R-Ariz., plan to begin hearings
next week to address excess defense spending.
McCain, the former presidential candidate, has called the
defense budget a "train wreck" filled with bloated programs.
U.S. Rep. Barney Frank, D-Mass., who heads the House Financial
Services Committee, said this week that it would make sense to cut
the defense budget by 25%, freeing up funds to be used for domestic
stimulus spending.
McCain and Levin plan to introduce the Weapon Systems
Acquisition Reform Act of 2009. Levin pointed to government
statistics showing that spending for the top 95 defense programs
last year ballooned by $300 billion from the original program
estimates.
The proposal could cause serious transfer of risk back to
defense contractors, said Howard Rubel at Jefferies & Co.
The key is to be sure costs are verifiable and controllable,
Rubel said. The system that has been used since World War II caps
the profits that defense contractors can make, although many
contracts grow over time.
Sacknoff cautioned that even if some programs are cut, they may
be expanded in the future, for political or practical reasons. In
any case, he said, the prime contractors tend not to change, since
other companies don't develop the same expertise to compete on
long-range projects.
Levin has singled out the U.S. Army's Warfare Information
Network, a communications program, and the Navy's Littoral Combat
Ship program, with a budget that has doubled to more than $500
million a vessel. The Army program is led by General Dynamics Corp.
(GD) and Lockheed Martin Corp. (LMT). Lockheed and Northrop Grumman
Corp. (NOC) are key players making Littoral ships.
While contractors await the five-year plan, some say that the
diversity of their businesses protects them from cutbacks on
individual programs.
Lockheed Martin Corp. (LMT), the prime contractor on Marine One,
and the Pentagon's largest supplier, for the first time this year
will generate more revenue from its technology and international
business unit than from traditional defense spending.
-By Ann Keeton, Dow Jones Newswires; 312-750-4120;
ann.keeton@dowjones.com