Sequestration's in full swing, and it's putting a kink in the Navy's ship-buying plans. Before sequestration took effect, the Navy signed a multi-year procurement contract, which saved money by buying ships in bulk. Now, however, the defense budget has been cut, and that contract's in jeopardy. This is bad news for defense contractors on the DDG 51 Aegis Destroyer contract and could also be bad news for investors. Here's what you need to know.
Who builds what
Both General Dynamics' (GD 3.94%) Bath Iron Works shipbuilding company and Huntington Ingalls Industries' (HII 2.52%) Ingalls Shipbuilding build the DDG 51 Aegis Destroyer, with the Navy typically buying ships from each builder.
In a move to save money, the Navy signed a 30-year shipbuilding plan that saw the purchase of 10 Aegis Destroyers for the price of nine. It also increased the Navy's shipbuilding budget from $15 billion to almost $19 billion annually. Now, Rep. Randy Forbes (R-Va.), chairman of the House Armed Services Committee, has expressed grave concerns about funding the 30-year plan and has asked the Navy for "a scintilla of evidence" that it can be done.
One of the reasons the Navy's costs are so astronomical is that the service also has to replace the Ohio, a nuclear-capable submarine dating to the 1980s. Adm. Jonathan Greenert, chief of Naval operations, has stated, "People ask me what is my No. 1 program of concern, and I will tell you it's the Ohio replacement program." Not only is the Ohio outdated, but the replacement program will also provide 70% of the United States' nuclear deterrent capabilities.
With the price of the new subs and the need for new ships, the Navy is seeing its costs escalating, which of course conflicts with the 10-year, $500 billion cut to defense spending under sequestration .
Will the Navy remain mission-capable?
Ships aren't the only area where the Navy is seeing cuts; the service was also planning on purchasing one P-8A maritime surveillance plane from Boeing (BA), one E-2D Hawkeye battle management aircraft and two unmanned Fire Scout helicopters from Northrop Grumman (NOC 3.27%), and one F-35C carrier fighter from Lockheed Martin (LMT 3.48%) -- all of which face being cut.
Clearly, this is all bad news for defense contractors. It's also bad news for the Navy, as it relies on these systems to remain mission-ready.
What'll happen to the Aegis Destroyer contract remains to be seen, but it's not looking great. If it does get cut, General Dynamics and Huntington Ingalls could see their stocks suffer. On the other hand, that might end up being a great time to load up on defense stocks at a discounted rate. Yes, sequestration is hurting defense, and contracts are being cut, but as I've said before, defense contractors are essential to the military. Consequently, while defense contractors may be hampered in the short term, in the long term I'm not too worried.