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Why the Pentagon Desperately Needs Defense Contractors to Keep Their Mouths Shut

By Rich Smith - Feb 17, 2014 at 10:00AM

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The real reason the Pentagon wants defense contractors’ record profits to stay on the down low.


Source: Congressional Budget Office.

"Going forward from '14, '15 ... hopefully, we've hit the bottom. If not, I think we're very, very close. ... So I'm, I'll say cautiously optimistic ... to see some growth in the not too distant future."
-- Lockheed Martin CFO Bruce Tanner 

"The major slide is behind us. ... I think we're getting close to the bottom."
--General Dynamics CEO Phebe Novakovic 

"Overall, we're pleased with the 2014 budget outcomes for our programs."
-- Northrop Grumman CEO Wesley Bush 

Dear defense contractors: Will you please shut up? Thanks a lot. -- The Pentagon
In just a couple of weeks, the Obama administration is expected to release its fiscal 2015 budget proposal, which among other things will outline the administration's view of where defense spending is headed over the coming year. As you can tell from the CBO chart up above, it's going to be hard to make a case for spending to go "up," given the U.S. government's sustained and continuing budget deficit.

To the contrary, for the Pentagon to get the funding it needs to pay its servicemen, buy essential weapons systems, and undertake other tasks for the nation's security, it's going to have to make some tough arguments: That defense spending has been cut drastically already. That belts have been tightened, cost-cuts implemented, defense contractors squeezed. And that it's time to loosen the money spigots again.

But as DefenseNews.com reports in a column this past week, America's defense contractors aren't making the Pentagon's job any easier, what with all the happy-talk they've been spouting lately. Quoting Pentagon acting industrial base chief Elana Broitman, DN notes: "We've gone through a lot of the year-end reports, and a lot of the larger companies in particular are reporting that while they've seen some of their sales take some small hits ... we're really at the nadir of the pressure on their sales, and that things are going to be really rosy from there."

A lone voice, crying in the wilderness
Not everyone's looking at the defense budget through rose-colored glasses, of course. After Boeing's (BA -2.84%) earnings report last month, company CEO Jim McNerney warned that the recent Congressional budget compromise really only "delayed the full impact of sequestration by 18 to 24 months by about a half ... so sequestration still lurks out there," and budgets are still tight.

But if Boeing's boss is worried, he's in the minority. Lockheed Martin (LMT 0.33%), General Dynamics (GD 0.50%), Raytheon (RTN), and Northrop Grumman (NOC 1.44%) -- if you go through the transcripts of what the CEOs and CFOs at these companies have been telling their investors these past few weeks, it's basically a story of a minor slowdown in revenue leading to a temporary slump in profit. According to most of Boeing's peers, the hard times will soon end, and defense spending will swing up again.

That is exactly not the message the Pentagon wants Congress to hear. Broitman again: "For us to be able to tell the story of what the sequester does to the defense environment, it's harder when there are good profits at some of the larger companies."

What it means to you
Investors so far have been pleasantly surprised at how little the sequester has bitten into their companies' profits. Last year, all five of the big defense contractors named above "beat" analyst earnings estimates with a stick -- every single quarter, and usually by double digits. (Other defense contractors have done even better. Last time Navy shipbuilder Huntington Ingalls reported earnings, for example, it exceeded expectations by 66%.)

But the share price performance at these companies has put even their profits performance to shame. The "Big 5" named up above have seen the value of their stocks rocket an average of 75% over the past year. Clearly, investors are still buying what the defense CEOs are selling. But considering that their No. 1 customer, the Pentagon, is telling us, maybe it's time to inject a bit of caution into this stock rally. 

Rich Smith has no position in any stocks mentioned. The Motley Fool owns shares of General Dynamics, Lockheed Martin, Northrop Grumman, and Raytheon. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Stocks Mentioned

The Boeing Company Stock Quote
The Boeing Company
BA
$167.20 (-2.84%) $-4.88
Raytheon Company Stock Quote
Raytheon Company
RTN
Lockheed Martin Corporation Stock Quote
Lockheed Martin Corporation
LMT
$441.59 (0.33%) $1.43
Northrop Grumman Corporation Stock Quote
Northrop Grumman Corporation
NOC
$492.51 (1.44%) $7.01
General Dynamics Corporation Stock Quote
General Dynamics Corporation
GD
$242.69 (0.50%) $1.21

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