Congress, Defense, and What You Need to Know Before 2016

President Barack Obama signs the Budget Control Act of 2011 in the Oval Office, Aug. 2, 2011. Image source: Pete Souza via Wikimedia Commons. 

In 2014, the National Defense Panel released a report that outlined the security threats America would face if Congress didn't find a solution to sequestration, also known as the Budget Control Act of 2011. Unfortunately, but not surprisingly, the BCA is still in effect, and as a result, the Army has to trim its active-duty troops by 40,000 soldiers. 

For defense investors, this is concerning because it points to Congress' inability to find a solution to the BCA even when faced with escalating security risks and significant troop cuts. Why should this concern investors? Because the continuation of the BCA poses some very real threats to companies like Lockheed Martin (LMT 0.01%), Boeing (BA 0.01%), and Northrop Grumman (NOC 0.10%).

Will backlog decline?
Although the BCA has been in effect for a few years, the aforementioned defense giants have seemingly remained unaffected. This is largely due to the nature of defense sales -- the government awards contracts for products that often take defense companies years to develop and then sell to the government. For example, Lockheed Martin won the F-35 contract in 2001, but it's still working to iron out the F-35's kinks and have it reach operational status.   

Specifically, when a defense company receives a multiyear contract -- like the F-35 -- that order is reflected in its backlog. Then, as work is performed and/or deliveries are made, the company bills the government, the government pays the bill, and that amount is recorded as a sale. Thus, backlog is critical to evaluating a defense company's future as it reflects future work. Consider the following:

Revenue backlog

Source: Lockheed, Boeing, and Northrop Grumman annual reports. 

When you look at the above table, none of the companies' backlogs seem overly concerning, even though they've all decreased since 2012. (Note: Boeing's backlog excludes commercial airplane orders and only reflects defense orders.) However, like I've said, many of the contracts awarded to defense companies take years to complete, and the BCA hasn't been around that long -- plus, in December 2013, the government passed the Bipartisan Budget Act of 2013, which increased discretionary spending through the government's fiscal year 2015.  As such, the effects of the BCA have been muted for defense companies.

U.S. Marine Corps Gen. John F. Kelly, right, the commander of U.S. Southern Command, testifies before the Senate Armed Services Committee, March 13, 2014. Image source: MC1 Daniel Hinton via Wikimedia Commons.

2016 and beyond
The reason this is important is that although the Bipartisan Budget Act provided budget relief through fiscal year 2015, it retained sequestration cuts for fiscal years 2016 through 2021. The good news is that as of this writing, Congress is debating H.R. 1735, National Defense Authorization Act for Fiscal Year 2016. If implemented, this bill would authorize appropriations above sequestration levels for FY 2016.   

Unfortunately, it doesn't provide long-term relief from the BCA. Considering the following 2014 revenue numbers:

1. Lockheed Martin received 79% of its $45.6 billion in net sales from the U.S. Government.  
2. Boeing made over $90.7 billion in total revenue; $60 billion came from commercial airplanes sales, but 30% of its revenue was earned pursuant to U.S. government contracts.  (65% of its almost $31 billion in defense sales were from the U.S. DoD, alone ).
3. 84% of Northrop Grumman's almost $24 billion in total sales came from the U.S. Government.  

So, while Boeing is in the best position thanks to its strong commercial segment, all three companies receive a substantial amount of money from the U.S. government. Consequently, the continuation of the BCA presents a problem because funding for government acquisitions will continue to remain uncertain, and defense spending will likely continue to face budget reduction pressure. This, in turn, could start to result in further declines in backlog, as the government is unable to commit to large, long-term, contracts.

To sum it up
The longer the BCA is in effect, the more defense companies' backlogs could be affected. So far, defense giants like Lockheed Martin, Boeing, and Northrop Grumman have seemingly remained immune, but that is due to the nature of defense sales and not because the BCA is toothless. Moreover, it is the nature of defense sales that could end up hurting these companies' backlogs -- large multiyear contracts will be harder to come by when the government is uncertain about future funding.

Image source: U.S. Air Force photo/Master Sgt. Jeremy T. Lock via Wikimedia Commons.

However, while the continuation of the BCA isn't ideal defense giants like these are unlikely to go anywhere. Yes, things could get bumpy through 2021, but while I wouldn't purchase defense stocks right now (unless there's a significant decrease in price), I'm also not selling, either. Still, defense investors would do well to closely monitor congressional defense bills.