Pentagon to Defense Contractors: We've Got Your Back

"It's backwards to say [Pentagon spending cuts are] about reducing profit ... It's not at all about that. It's about reducing cost."
-- Ashton Carter, Undersecretary of Defense for Acquisition, Technology, and Logistics

Way to break it to 'em gently, Mr. Carter. On Monday, as Defense Secretary Robert Gates reiterated plans to cut in excess of $100 billion from Pentagon spending over the next five years, the Pentagon trotted out Gates' subordinate to reassure investors that the Obama administration comes in peace, and is not out to hurt anyone -- least of all investors. But how did investors respond to the news?

Considering that it makes the Global Hawk, an unmanned aerial vehicle singled out for being "on a path to be non-affordable," Northrop Grumman (NYSE: NOC  ) actually got off lightly, suffering only a 0.3% drop yesterday. Lockheed Martin (NYSE: LMT  ) , maker of the country's most expensive weapons system ever, escaped with only a 0.6% hit. But the news got worse from there.

United Technologies (NYSE: UTX  ) fell 1.1%. General Dynamics (NYSE: GD  ) dropped 1.5%. Boeing (NYSE: BA  ) shares slid 2%. And Textron (NYSE: TXT  ) , despite announcing receipt of a sizable Air Force contract, plunged the hardest of all, taking a full 3.4% hit on the day. More losses followed on Tuesday in a generally chaotic market.

Call me crazy, but it doesn't look to me like investors are buying the company line.

Watch your six
But why not? When the Pentagon's going out of its way to reassure the major defense companies that (I paraphrase) "we've got your back, and your profits are safe," why would investors worry? Call me a skeptic, but looking past the happy talk, I think investors see a bogey on their tail.

According to the Defense Department, the government's all for growing defense purchases. In fact, they're hoping to see 3% a year or so growth on the "sharp end" -- the actual bullets and MRE-issued butter they get for their defense budgetary dollars.

So belt-tightening is coming -- maybe by the $100 billion Gates says he wants, or maybe by the $1 trillion that the Sustainable Defense Task Force advocated earlier this month. One way or another, however, the cuts are coming. But how will they happen?

Know when to fold 'em
Undersecretary Carter promises that Pentagon spending reforms will yield "higher productivity with higher profits" for the defense contractors. But in the real world, that's an unlikely scenario. The Pentagon aims to find savings in two ways, neither of which seems likely to result in higher profits.

First, it aims to scrap programs that Gates characterizes as not "necessary or sensible." General Dynamics' $13 billion amphibious landing craft; the alternate engine for Lockheed's F-35 fighter, being offered by General Electric (NYSE: GE  ) ; and Boeing's endless stream of C-17 transport aircraft all might qualify.

These are the high-profile targets, but further down the food chain, the Pentagon more generally wants contractors to cut "unproductive or low-valued overhead." This sounds unobjectionable, but consider what it means in the incestuous world of Pentagon defense contracting, where even losing bidders on high-value contracts often receive lucrative subcontracts from the winners.

I've got mine, Jack
For example, Lockheed "builds" the F-35 for the Pentagon, right? If it cuts the cost of building the plane, it should reduce the Pentagon's invoice cost. It might even cut Lockheed's cost and boost the company's profits. But check out the list of suppliers on this plane -- it reads like a who's-who of everybody-else-in-the-defense-industry. United Technologies builds the engines. Boeing and Raytheon make the bombs, while General Dynamics installs the machine guns. Northrop provides fire-control radar ... and on and on.

So almost any move Lockheed makes to "control costs" -- whether by bringing functions in-house to shorten the supply chain, or by holding subcontractors' feet to the fire to do things more efficiently -- will pinch the revenues of a whole host of companies. And turnabout is fair play. What happens when Northrop Grumman is told to reduce the price tag on one of its aircraft carriers? Or when Boeing gets a memo to cut costs on its Airborne Laser program, or see it canceled?

Do the Pentagon hokey-pokey
The prime contractors on these projects will squeeze their own subcontractors -- companies which, on other projects, for other products, are prime contractors.

Undersecretary Carter's assurances to the contrary, these cost cuts will slash profits for all major players. Eventually, everyone's going to have to put a foot or a hand inside the circle. And just as soon as they do, the Pentagon's going to lop it off. Adjust your expectations accordingly.

General Dynamics is a Motley Fool Inside Value recommendation, but Fool contributor Rich Smith does not own shares of any company named above. The Motley Fool has a disclosure policy.


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