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.
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.
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.
If you’re a more cautious investor, the safest places in the defense industry are the diversified giants. Conglomerated United Technologies
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.