What's in Store for Defense Contractors in the Second Half of 2012?

This article is part of the Fool's Halfway Through 2012 series, in which we review how sectors have done since January and see what's coming for the rest of the year. Click here to read all of the articles.

2012 has been... I suppose you could say... an "interesting" year for the defense industry in America. At least, interesting in the sense of the apocryphal Chinese curse, wishing you "interesting" times to live in.

The big story so far this year, and likely for the next five or so months, is of course sequestration. As you may recall, back in February the U.S. Congress attempted a gambit that would, in one fell swoop, cure America of its habit of overspending and underpaying-for-its-spending. It locked several legislators in a room (figuratively speaking), under strict instructions to agree on $1.2 trillion worth of specific, targeted spending cuts and revenue increases. Failing that, drastic cuts would automatically be made in equal measures to the Democrats' and Republicans' respective sacred cows -- social spending and defense.

You'll be shocked to learn that they failed to come to any such agreement.

As a result, we've spent the first six months of this year wondering where, exactly, the budget ax will fall. The answer: The ax is falling, but it's cutting rather unevenly:


Revenue Change vs. Previous Quarter

Earnings Change vs. Previous Quarter

Boeing (NYSE: BA  ) +30% +58%
Lockheed Martin (NYSE: LMT  ) +6% +26%
Raytheon (NYSE: RTN  ) -2% +17%
Northrop Grumman (NYSE: NOC  ) -8% -4%
General Dynamics (NYSE: GD  ) -3% -9%

Note: Both columns are calculated using year-over-year comparables.

On one hand, as the Pentagon makes proactive spending cuts in anticipation of sequestration, companies like General Dynamics and Northrop Grumman seem to be starting to feel a pinch. That's surprising, considering the high-profile contracts that both firms own. General D, for example, is one of the two primary contractors (Lockheed is the other) building the U.S. Navy's next-generation coastal warfare vessel, the Littoral Combat Ship. Meanwhile, Northrop is one of the leading companies involved in unmanned drone aircraft, machines taking a prominent role in the military's new strategies.

On the other hand, Raytheon, Lockheed, and Boeing in particular -- buoyed by its commercial aircraft business -- are all doing surprisingly well... so far.

What's next for America's defense contractors?
When it comes to defense, investors should probably expect more of the same as this year progresses, unless the current inhabitant of 1600 Pennsylvania Ave. has to fill out a change-of-address form after November's election.

Why? Because in the event the president gets a second term in office, we already know what his plans are for defense policy. So it shouldn’t be too difficult to identify the winners and losers. This will remain true even if sequestration never actually happens -- and in that regard, it's worth noting that just last week, Sen. Joe Lieberman (D-Conn.) noted that it is "overwhelmingly" unlikely that sequestration will be allowed to happen.

Still, having once ignored Vizzini's advice to "never get involved in a land war in Asia," the current administration is none too eager to engage in any new land-based conflicts. That might not be great news for companies like General D, which, while it has its fingers in many pots, is still primarily known as a manufacturer of main battle tanks, lightly armored "Stryker" personnel carriers, and more recently, the mine-resistant ambush-protected, or MRAP, armored trucks in wide use in Afghanistan and Iraq.

The president does, in contrast, appear to be committed to Lockheed and its F-35 fighter jet program -- not least because for the time being, there's really no alternative to the new fifth-generation fighter. Similarly, Boeing has a lock on the contract to rebuild America's aerial refueling fleet, and Raytheon's expertise in long-distance rocket-building is going to be forever in vogue in a military that emphasizes keeping a safe distance from the guys it's shooting at.

The wild card
The one stock I'm unsure about, honestly, is Northrop. On the one hand, the company certainly hasn't fared well so far this year. But on the other hand, it's taken a commanding lead in the military's switch to unmanned aerial vehicles -- churning out Fire Scouts, Global Hawks, and other UAVs by the score.

Given the president's obvious enthusiasm for expanded use of UAVs in the fight against al-Qaeda, this should stand Northrop in good stead. When you consider, too, that Northrop's P/E ratio of 8.4 is currently one of the lowest in the industry -- and lower than that of any of the other large defense contractors named above -- this suggests that Northrop, underappreciated and overly sequestered though it might be, is actually one of the better bargains among defense stocks today.

This article is part of the Fool's Halfway Through 2012 series, in which we review how sectors have done since January and see what's coming for the rest of the year. Click here to read all of the articles.

Fool contributor Rich Smith does not own (or short) shares of any company named above, but The Motley Fool owns shares of Lockheed Martin, Northrop Grumman, General Dynamics, and Raytheon. The Motley Fool has a disclosure policy.

Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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