How Will U.S Budget Cuts Affect These Defense Stocks?

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Investors and analysts' concerns regarding potential U.S. budget cuts in general, and the U.S. defense budget in particular, may have contributed to the slowdown of defense stocks such as Lockheed Martin (NYSE: LMT  ) and Boeing  (NYSE: BA  ) , which rely heavily on the U.S. Defense Department's budget. Looking forward, how will the expected budget cuts affect these companies' revenue growth? 

U.S defense budget cuts in 2013 
In 2013, U.S. policymakers decided to cut the federal budget by $85 billion. These cuts, along with higher budget receipts, led to a lower deficit increase in 2013 (year to date) compared to last year. The budget cuts have also reduced the Department of Defense's budget by nearly 6.8% (year to date.) This drop in expenses is likely to appear in the financial reports of defense companies such as Lockheed Martin and Boeing.

Moreover, U.S. policymakers are likely to further cut the budget for next year, which may result in an even lower budget for the Department of Defense, further dragging down these companies' revenues.

Let's see how these changes will affect defense companies and their recent performance. First, we'll examine how these companies have done so far this year.  

Revenues aren't rising
Lockheed Martin  will likely suffer most from future budget cuts. In the second quarter, the company's revenues fell by 4.3% year over year. In comparison, other defense companies such as Boeing and Northrop Grumman (NYSE: NOC  ) were able to increase their sales: Boeing's net sales rose by 9%, while Northrop Grumman's revenues inched up by 0.3%. 

During the past quarter, 82% of the company's net sales came from the U.S. government, with 61% coming from the Department of Defense. The company acknowledges  that the sequester will lead to a $37 billion cut in the Defense budget, to be implemented in the last quarter of 2013. This could mean that even before U.S. policymakers decide on next year's budget, Lockheed Martin could see an additional drop in revenues in the last quarter of 2013.

For the first half of 2013, the company's revenues were down by 3.2%, which is in line with the company's outlook for the year: a decline between 2.5% and 5.7%.

Despite the drop in revenues, the company's operating profitability grew to 11.4% in the second quarter. This is getting closer to Northrop Grumman's profitability.

The rise in profitability was mainly in the missiles and mission systems segments. In the missiles segment, the rise in profitability was due to higher risk retirements; in the mission systems it's related to settlement of contract cost on certain programs.

The chart below compares the profit margin of Lockheed Martin to other defense stocks, including Boeing and Northrop Grumman.

As seen above, neither Boeing nor Northrop Grumman were able to increase their profitability while Lockheed Martin was able to. If Lockheed Martin continues to increase its profit margin, this could partly compensate for the lack of growth in sales; this could also result in higher dividend payments

Northrop Grumman also expects its revenues to decline during 2013 by 3.7%. This is mainly because of the ongoing fall in sales in information systems and technical services business segments. The U.S. government's budget cuts are likely to also further reduce the company's revenues.

On the other hand, Boeing projects its revenues will grow by 1.6%-5.3% during the year. So far (based on the first two quarters of 2013), the company is inline with its projection. For Boeing, the potential drop in revenues from the U.S. budget cuts may be less severe as its Defense, Space, and Security segment accounts for 40% of its revenues. Its commercial airplanes segment accounts for its entire growth in revenues. 

Based on the above, defense companies either aren't expecting to grow, as in the case of Lockheed Martin and Northrop Grumman, or are expected to grow only slightly, as in the case of Boeing. These companies' revenue growth could further fall due to additional U.S. budget cuts next year. 

Budget cuts and defense companies 
Let's make a back-of-the-envelope calculation to consider how the U.S. budget cuts may affect these companies' revenues. Assuming that the U.S. defense budget gets slashed by around $37 billion, as Lockheed Martin projects (and let's be generous and assume that this will be the only budget cut), that would represent a 6% cut to the$610 billion budget to the Department of Defense during this year. Assuming that this reduction will spread out evenly across the department, Lockheed Martin could experience a 5% drop in its revenues. 

For Boeing – a company that gets 70% of its Defense, Space, and Security segment revenue from the U.S. Defense Department -- that cut would shrink its total revenue by 1.7%. Keep in mind, however, that Boeing still has its commercial airplane operations, which will offset that potential drop. 

Defense budget cuts will likely slash Boeing and Lockheed's revenue growth by several percentage points. But these companies' true strength lies not in that growth, but in their high profit margins, stability, and reasonable dividend yields -- all of which will almost certainly stick around.


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