The Trillion-Dollar Question

Editor's note: A previous version of this article incorrectly stated that sequestration would begin in June 2013, instead of in January 2013. The Fool regrets the error.

Sequestration, the automatic budget cuts for various U.S. government programs, is no laughing matter for major defense contractors. If Congress doesn't act to stop the cuts from taking place, they will begin in January 2013 and reduce the U.S. defense budget over the next 10 years by $492.3 billion. And that would be on top of around $500 billion already slashed over the next 10 years. While many government defense contractors are exposed to the budget cuts, one company that may have more to lose than any other is Northrop Grumman (NYSE: NOC  ) .

In defense of defense
Northrop Grumman, a self-proclaimed "leading global security company" and one of the biggest defense contractors in the U.S., received approximately 90.5% of its 2011 revenue from contracts with the U.S. government, including:

  • Constructing the new Ford-class supercarriers, which eventually will replace the U.S. Navy's current fleet of carriers.
  • Production of two X-47B stealth unmanned aerial vehicles, the first UAVs capable of being launched from an aircraft carrier.
  • Developing the NG-ADS, a fully autonomous early warning service for biological attacks in major metropolitan areas.
  • Streamlining the Military Health System through advanced information technology and modernization of current systems.

The diversity of products will probably be an edge for the company once the ax falls on several defense programs beginning January 2013; the problem is that it doesn't matter if the company is well diversified within one sector if that sector is about to get decimated with budget cuts.

On the attack
Several other defense contractors share Northrop's overexposure to the U.S. government; however, even when you compare Northrop Grumman's financials to those of other defense contractors, the company doesn't make a very compelling case.

Company

P/E

Dividend Payout Ratio

Dividend Yield

Net Margins

Return on Equity

Debt-to-Equity Ratio

Northrop Grumman 8.20 26% 3.50% 8.1% 18.1% 0.37
Lockheed Martin (NYSE: LMT  ) 10.40  41% 4.60% 5.9% 103.5 4.11
General Dynamics (NYSE: GD  ) 9.60     28% 3.10% 7.6% 18.0 0.28
Industry Average 12.50 28% 6.60% 0.07 N/A 0.59

While Northrop may be cheap compared to Lockheed Martin or General Dynamics, this may be a result of Northrop's exposure to budget cuts being priced into the stock. You'd do a lot better with a company like Lockheed in your portfolio; it pays a higher dividend, has great return on equity, and is reasonably priced compared to the industry average. Most important, Lockheed only got 61% of its 2011 revenue from the Department of Defense.

The best defense is a good offense
Of course, defense contractors aren't taking these budget cuts lying down. Several contractors have stated that they will have to notify their employees 60 days ahead of layoffs that they will be fired; this means that pink slips could be handed out in early November. If making hundreds of thousands of voters angry just days before a major election doesn't get Congress' attention, what will?

Beat a tactical retreat
The upcoming budget cuts have put the future of Northrop Grumman in the balance. Cutting the Department of Defense's budget won't destroy Northrop Grumman, but fear of said destruction will likely send its stock price down in the short term. Ultimately, the lack of funding and contracts will wreak havoc on the company, unless it finds different markets outside of the U.S. or expands its range of products into the commercial sector.

Just because Northrop Grumman may not have a bright future doesn't mean every stock will get slaughtered after the election. If you want some stock ideas that will look great no matter which party wins in November, check out our special free report: "These Stocks Could Skyrocket After the 2012 Presidential Election."

Fool contributor Mark Reeth holds no financial positions in any of the stocks mentioned above, which seems pretty smart given all the budget cuts he talked about. Follow him on Twitter @ChristmasReeth. The Motley Fool owns shares of Northrop Grumman. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days. The Motley Fool has a disclosure policy.

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