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"Fire in the hole!"
He didn't come right out and shout it, but Defense Secretary Robert Gates probably should have given investors a warning of this sort earlier this month, when he announced plans to slash the defense budget by $100 billion. Across the length and breadth of the military-industrial complex, defense contractors are hunkering down, and preparing for the worst.
It's not exactly as if Gates has been shy about acting on past threats, after all. Last year we described a whole series of cuts implemented at his behest; one after another, multi-billion dollar efforts to develop Future Combat Systems, build F-22 Raptor fighter jets, and test an Airborne Laser fell to the budgetary axe.
What's next on Gates' chopping block? The secretary hasn't exactly kept it secret. In recent weeks, he has criticized:
- General Electric's (NYSE: GE ) proposed alternate engine for the Lockheed Martin (NYSE: LMT ) F-35 fighter, which "probably does not meet the performance standards that are required." (For the record, GE disputes the characterization, arguing its engine is "exceeding all of its performance goals" -- but admits it will need at least $1 billion to complete development.)
- Boeing's (NYSE: BA ) C-17 transport aircraft, lumped in with the GE engine under the category "unneeded programs."
- General Dynamics' (NYSE: GD ) $13.2 billion amphibious landing craft. Neither "necessary [n]or sensible," says Gates.
- And Northrop Grumman's (NYSE: NOC ) aircraft carriers? "Do we really need 11 carrier strike groups …when no other country has more than one?"
But if all of that isn't enough to shake defense investors' confidence, there's a new report out that suggests Gates' wide-ranging axe-wielding is only the beginning.
Remember the Lorax
So far, Gates has been waging a one-man logging expedition in the defense industry thicket. He's quick with an axe, but to really do some damage, you need a Lorax-style chopping machine -- and wouldn't you know it? One just appeared.
A couple weeks back, the "Sustainable Defense Task Force" -- a group comprising policy experts and spending activists, backed by Reps. Barney Frank on the left and Ron Paul on the right -- published a report proposing to take Gates' $100 billion, five-year defense cuts and expand them five to 10 times. Over the course of a decade, the SDTF argues we should cut defense spending by nearly $1 trillion (all the cool analysts these days use the "T" word. "Billions" are so last millennium).
Now, the report stretches to 40 pages in length, so I won't bore you with the details. But here are the highlights: For starters, SDTF takes every program that Gates wants to cut and stamps it "Approved." But that's just the beginning.
SDTF would also cancel Textron's (NYSE: TXT ) V-22 Osprey tilt-rotor aircraft, further postpone implementation of the KC-X Tanker Program, and slash the U.S. Navy 20% in size, retiring two aircraft carrier battle groups and cutting the fleet to 230 ships. Also retired from service: Thousands of nuclear missiles, 50,000 ground troops in Europe and Asia, and the entire F-35 fighter jet program (which was just getting warmed up).
Clearly, these proposals will spark controversy. Naturally, I've got my own opinions of 'em … but I'm not getting into a policy debate here. (However, if you want to debate the wisdom of the military rollback, and the necessity of curbing deficit spending, feel free to do so in the comments section below.) Rather, I want to highlight two crucial points investors need to consider in light of the SDTF's proposals.
Death by a trillion cuts
First, we're no longer talking about a "$100 billion scenario." When Gates suggested cutting spending by $100 billion over five years, the logical assumption was that presidential-congressional horse trading would ensue, resulting ultimately in Pentagon spending cuts somewhere above $0, but below $100 billion. That scenario is now out the window. Now we're more likely talking cuts of somewhere between $100 billion and $1 trillion over the next decade.
This is not good news for investors in defense companies. Revenues will drop, valuations will fall, and industry consolidation is likely as the defense majors scramble to shore up their revenue streams. (On the plus side, they'll probably do this by buying up smaller players like UAV-specialist AeroVironment (Nasdaq: AVAV ) , so keep your eyes peeled for M&A activity. Acquisition premiums are in the offing.)
As the world turns, the pendulum swings
A second investment opportunity may open in Europe. Here's why: Few would argue that the U.S. needs to spend $500 billion a year and more to "defend" itself. We've got, what? Canada to our north, Mexico to our south, and what on our flanks? The Maginot Line's got nuthin' on the U.S. Simply put, America is not a nation surrounded by enemies. We spend $500 billion a year not to defend ourselves, but to defend our interests, and our allies, around the globe: Protecting international shipping lanes. Dissuading Somali pirates. Combating international terrorism.
Whatever your opinion of how much we spend on the efforts, you cannot deny that the tasks need doing -- and if the U.S. rolls back its spending on these fronts, chances are, someone else is going to have to step in and fill the gap. Will it be booming industrialist China that picks up the slack? A re-emergent Japan? Or will Europe find its way out of its economic hole and increase its historic underinvestment in defense?
Whoever the "somebody else" turns out to be, it's likely we'll see their defense companies grow in revenues and earn more profits going forward. As U.S. defense spending shrinks, the world is turning multipolar again. Invest accordingly.