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How These 3 Defense Contractors Could Respond to Spending Cuts

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Given the current budget uncertainty and the declining trend in U.S. defense spending, no military contractor has assurance that it will continue to receive high-value contracts at regular intervals in the future. Sequestration alone led to a 7.3% defense budget cut this year, raising concern. In addition, if we consider the gradual cutback in troops from Afghanistan, the defense industry's outlook seems dark. Given these circumstances, how are defense companies performing?

Foreign sales giving hope
First, we have Raytheon (NYSE: RTN  ) , a 68,000-employee defense company.

Raytheon's third-quarter flat earnings and revenue were not impressive. Net sales decreased 3.4% year over year to $5.8 billion, and cash flow went from $1,111 million last year to $895 million. Thanks to higher demand in Persian Gulf countries, the company's numbers are not worse.

The company's prominent missile and space systems programs, along with its diligent focus on technological advancement, like the GaN systems, should bring new profitable orders in the future and counter the sequestration effect. For now, we should rely on the company's business consolidation initiative, which will bring cost-saving solutions and improve its bottom line. In fact, Raytheon improved its operating margin 10 basis points to 13.7% this quarter already.

Another positive is that the company is increasing its foreign military contracts, which represent 27% of total revenues and grew 6% this last quarter. In fact, this quarter Raytheon secured sizable orders from the Dubai Air Show, and a security contract from the Philippines government. Locally, it got a $353 million order for its Aegis weapon systems for the U.S. Navy.

New contracts
Second, we have a prime contractor in communications and surveillance systems, L-3 Communications Holdings (NYSE: LLL  )

The company reported mixed third-quarter results, which included an 8.7% year-on-year decrease in net sales to $3 billion. Just like with Raytheon, a steady inflow of international orders, especially new orders from Gulf and Asian countries, were a key factor to offset the performance.

Strategy-wise, L-3 combines a non-platform focus on shorter cycle contracts with a great ability to capture new contracts and replace the old ones. This goes along with the company's diversification of programs and constant effort to upgrade its technology, which helps it deal with changes in defense spending priorities. Managing to identify needs and score new contracts is key, and L-3 well-positioned when it comes to it. Recent contracts include a $357 million task order from the GSA Federal Systems Integration and Management Center, and a $161.7 million in defense support, maintenance and modification contracts. Plus, L-3 obtained a $14 million research and development government tax credit that will boost its net profit in the next quarters. However, the company's dependency to the U.S. spending remains substantial, as 27% of consolidated net sales comes from international customers.

Disappointing performance
Finally, we have a leader in design and manufacture of thermal imaging systems, FLIR Systems (NASDAQ: FLIR  ) .

The company announced year-over-year declines of 13.5% and 7.8% in earnings and revenues, respectively, for its third quarter. Organic revenue also declined 2% following unexpected delays in delivery and poor performance in its government segment.

Despite FLIR's moderated price structure and best quality services, budget delays and stringent regulatory compliance will continue to hurt the company. In fact, FLIR's government division's revenue declined 4% year over year, driven by a significant drop in volume. FLIR is executing a strategic realignment plan, which includes the shutdown of three European facilities, but those constructive efforts may not be enough to get the company out of its slump.

Bottom line
Raytheon faces a challenging environment. Even though the company is improving its margins and foreign contracts, its performance remains unimpressive.

Despite its reasonable diversification, L-3 remains exposed to business generated within the U.S. Since the company works on short contracts, it will be important to monitor new contract generation.

FLIR is suffering from the tough domestic government procurement environment. Even if we see significant productivity and profitability gains, they'll take time to realize.

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5/27/2016 4:00 PM
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