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What Does Sequestration Mean for Your Defense Picks?

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In the world of defense contractors, the word "sequestration" -- automatic government budget cuts brought about by last year’s debt debate -- hangs around like a bad house guest. Investors can’t help but fret about looming fiscal cuts that will supposedly send major defense stocks reeling, and have politicians panicking as if the world were ending. While Capitol Hill battles over whether or not the cuts will actually happen, you need to prepare for how potential sequestration will impact your portfolio.

Defensive budgeting
The Department of Defense (DoD) will need to slash its budget by 10.3% under sequestration. However, actual procurement outlays -- money going out the door to new projects and contracts, such as aircraft orders -- would only fall by 3.5%, a much more manageable number. Because many contracts gain funding approval significantly before they are fulfilled, blows to procurement orders  likely wouldn’t hit defense corporations hard in 2013.

Operations and maintenance (O&M) outlays, which Congress typically funds the same year that they're distributed, would take a much harder hit. Contractors in this area of upkeep, repair, and all sorts of short-term and existing projects, would feel the harsher hit of a 6.9% reduction, sinking from nearly $300 billion, to around $275 billion. With 69% of O&M outlays designated for the same year as they are approved -- compared to 22% for procurement and 49% for research and development outlays -- the impact here would be sudden and drastic.

Lockheed Martin (NYSE: LMT  ) chief executive Robert Stevens cranked up the fear machine in June, threatening widespread layoffs and disrupted contracts that would cost the DoD significantly in reworked deals. But just how much would this all hurt his company and the rest of the defense field – and, by proxy, your investments?

What should you watch for?
Lockheed’s pricey F-35 fighter program tends to take the brunt of public criticism, but this company looks well-positioned to withstand the DoD’s future budget priorities. Additionally, the fighter’s geographic diversity of customers provides Lockheed a buffer against U.S. cuts, and should see considerable profit for the company, given the need for many first-world militaries to upgrade their air fleets.

On the down side, the operations-heavy nature of Lockheed’s electronics and information systems divisions made up more than 50% of the company’s 2011 revenues. Investors will need to keep an eye out in this area for just how hard those aforementioned O&M outlay cuts hit in 2013.

Northrop Grumman (NYSE: NOC  ) faces this same concern in its service-heavy electronics, aerospace, and technical branches, particularly as the government looks to wind down active overseas conflicts. Fortunately for these companies, the DoD’s planned focus on ISR -- intelligence, surveillance, and reconnaissance -- systems to combat terrorism, and similar threats in the future, should help these divisions thrive.

General Dynamics (NYSE: GD  ) is the big loser here. The company produces a number of major capital-intensive products, such as pricey warships and tanks, which are poorly suited for the military’s future plans of a mobile, high-tech force. With the DoD prioritizing a smaller navy, and reducing shipbuilding orders, investors should be worried that almost a sixth of General Dynamics’ 2011 revenues came from naval ship construction contracts. The company could find itself with declining future orders, as the military shifts away from Cold War-era solutions to global conflict.

If you’re a more cautious investor, the safest places in the defense industry are the diversified giants. Conglomerated United Technologies (NYSE: UTX  ) and aerospace titan Boeing (NYSE: BA  ) both boast of far more private sector contracts and ability to withstand government cuts than do the strict defense contractors. Boeing only took in 38% of revenue from the American government in 2011, a number that could shrink with its rollout of the new 787 passenger aircraft. In comparison, defense-centric contractors, like Northrop and Lockheed, take in more than 80% of revenues from the U.S. government.

Murky waters ahead
Nobody knows whether or not sequestration will even happen at this point. Panicking politicians and corporate leaders griping about job losses make this fiscal reality a tough pill to swallow for Wall Street and Capitol Hill alike. While it’s impossible for any investor to predict the future, you can make the right moves now to protect your exposure to the defense sector should the worst come to pass.

Corporations like Lockheed and Northrop look to be in good with their considerable investment in information and electronics services and systems. The diversified giants, like United Technologies and Boeing, should also be fine. For those of you invested in General Dynamics, however, you may wish to reevaluate your positions if the looming fiscal cliff hits.

You should be concerned about sequestration, but that doesn’t mean you can’t make the right moves to safeguard your money before the cuts strike. To get the information you need to plan ahead, check out The Motley Fool’s free special report, "These Stocks Could Skyrocket After the 2012 Presidential Election." Don’t get caught unaware; get your copy today by clicking here.

Fool contributor Dan Carroll holds no positions in the stocks mentioned in this article. The Motley Fool owns shares of Northrop Grumman, Lockheed Martin, and General Dynamics. The Motley Fool has a disclosure policy. 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.

Read/Post Comments (3) | Recommend This Article (2)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On September 07, 2012, at 8:56 AM, CCAgain wrote:

    Interesting. The largest issue is that each of these companies new business bid pipelines have stopped pending resolution. The DoD and 3 letter agencies have stopped progressing the new business proposals, pending clarity from out President and Congressional sources. In fact existing development programs are stalling due to internal discovery efforts on what will be chopped is Sequestration in fact becomes the law.

    Insanity - the primary purpose of having a government is for defense of the nation.

  • Report this Comment On September 07, 2012, at 10:47 AM, cnyap wrote:

    $300B seems high/incorrect. Procurement is around $120B (annually). R&D is $80B. Add $300B and we're at $500B total, but we haven't paid the troops yet. The total base/core defense budget is only $553B.

  • Report this Comment On September 07, 2012, at 10:54 AM, cnyap wrote:

    That's not 100% true (in response to CCAgain) - ALL proposals have not been stopped. The 3DELRR for example is progressing (it's been slow though to move forward). Three prototype/development contracts were awarded recently.

    Search and Rescue helo RFPs/proposals, which have been dragging on for years, is finally inching forwards (I believe the RFP is out or will be soon - we shall see if the gov't actually makes an award though).

    But it is true that the industry in general is hurting for new development work, which is why I'm unemployed after 20 years (with a MSEE degree).

    When the heck will the Presidential helo be restarted? Would be interesting to know how much we've wasted maintaining and upgrading the oh-so-old current fleet of under performing helos.

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