"Fiscal cliff." We've been hearing about this phenomenon for months now. And -- happy day! -- with a couple of weeks to go before the new year arrives, pretty soon we'll find out finally just what the heck this fiscal cliff thingy is.
But... would you perhaps like to know more about the fiscal cliff before we all go tumbling over it? Then wonderful news! Christmas has come early for you, Fool, because in this series, we aim to tell you just what to expect from the fiscal cliff, and give you enough time to prepare yourself (and your portfolio) for it. Today's topic:
The biggest fiscal cliff event for defense contractors next year is obviously sequestration. As you probably remember, the U.S. Congress tried to fix its fiscal fiasco by locking several legislators in a room (figuratively speaking), under strict instructions to agree on $1.2 trillion worth of specific spending cuts and tax increases. Failing that, drastic cuts would automatically be made in equal measures to the Democrats' and Republicans' respective sacred cows -- social spending and defense.
Naturally, they failed to come to any such agreement.
As a result, by law, next year the Pentagon must begin implementing a 10-year program involving some $600 billion in spending cuts. On top of cuts the Pentagon has already offered to make, this works out to roughly $1.1 trillion in total spending reductions, or about $110 billion per year.
That sounds like a lot of money -- and it is. President Obama's budget request for fiscal 2012, for example, came to $671 billion (including $553 billion as the base spending level, and an additional $118 billion for operations in Iraq and Afghanistan). If the $110 billion in cuts are applied to this number, therefore, we're looking at defense cuts on the order of 16.4%.
That said, the news isn't quite as bad as it sounds -- and herein lies your opportunity as an investor. If too many people overreact to the big number, without understanding the nuances, it's likely we'll see a similar overreaction in the selling off of defense stocks. They may become "too cheap" and, as a result, "good bargains" for investors who know what's really up.
So what is really up?
First off, it's important to note that a big chunk of the "cuts" in defense spending over the next 10 years will come from the government no longer needing to spend $118 billion a year conducting war operations in Iraq and Afghanistan. The former war has mostly ended. The latter, if you believe the government, will be winding down any year now.
Now, sure, much of this $118 billion still gets spent on equipment manufactured by the defense contractors. The skies over Afghanistan today are practically filled with Shadow UAVs from Textron (NYSE: TXT ) , F-16 fighter jets from Lockheed Martin (NYSE: LMT ) , helicopters, UAVs, and even more fighter jets from Boeing (NYSE: BA ) . On the ground, it's Oshkosh (NYSE: OSK ) MRAPs and General Dynamics (NYSE: GD ) tanks and Strykers galore.
Draw down forces in Afghanistan, and you'll soon be spending a lot less money on repairing, servicing, and replacing all this hardware -- and, yes, that'll hurt the defense contractors who make the stuff. But a lot of the savings from overseas operations will come in the form of not paying combat wages to troops, not paying logistics contractors to supply troops, and so on. Those kinds of "spending reductions" won't affect traditional defense contractors nearly as much as the headline numbers might suggest.
While we're on the subject of things happening "over there"... you may not have noticed, but things aren't all peaceful and tranquil around the globe these days. Libya just finished up a pretty brutal civil war, and no sooner did that wind down, than a new civil war broke out in Syria. Al-Quaeda's still out there, and Israel just got finished a short shooting war with Hamas. Pakistan's a basket case. For that matter, Afghanistan itself probably won't turn into a model of civil society and international harmony the moment U.S. troops depart.
Even if the U.S. is able to ratchet back defense spending in the face of all this turmoil, countries located closer to the fray may well not. Need proof? Saudi Arabia just finished negotiating the biggest foreign arms sale ever (or at least since Lend-Lease), throwing an estimated $90 billion at U.S. defense contractors, and buying enough weapons to almost single-handedly offset a year's worth of U.S. defense spending cuts.
Foolish final thought
Meanwhile, the Middle East is just one area where countries can be reliably expected to keep spending on weapons systems, even if we cut back. Elsewhere, China is flexing its military muscle, and North Korea is playing with rockets. Last time I checked, Russia was still out there as well. Long story short, there's no dearth of threats in this world of ours, and no shortage of countries that will pay up to defend themselves against them.
I'm not saying things will be easy for defense contractors on the other side of the fiscal cliff, but... the name notwithstanding, it's really not all downhill from here.
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