The Budget Control Act of 2011 brought a new term into the English vocabulary: sequestration. The new political jargon means the activation of automatic spending cuts when the sovereign debt reaches the “ceiling.” The act became law in March 1, 2012, and the US Department of Defense delayed, stalled or eliminated projects. It is possible to argue that defense contractors have suffered equally across the board. Let me look into Lockheed Martin (LMT), General Dynamics (GD) and Northrop Grumman (NOC) to see what future prospects hold for them.
LMT is the third largest defense contractor in the industry with a market cap of $39 million – behind Boeing (BA) ($78 million) and EADS (EADSY) ($48 million), but is the largest U.S. defense contractor. The firm engages in research, design, development, manufacture, integration and sustaining of advanced technology systems, products and services. After The Sequester became law, the company said: fiscal impasse continues to greatly complicate our ability to plan, make necessary capital investments, and recruit.
Since the sequester, LMT’s aeronautics segment has been pushed by new orders of the F-16 fighter jet. The bad news is that the firm started to reduce its workforce in an effort to improve margins. Also, delays have been announced in the development of the F-35 fighter yet, and no new projects are expected to be introduced by the department of defense. International expansion is difficult because the company’s jewel, the F-22, is not authorized to be sold to other countries. Hence, the firm’s future has been double whammed by the sequester.
A moderate balance sheet will help LMT curb defense cuts in the short term. However, the lack of growth prospects in the information systems, space systems and missile and fire control segments will pressure finances in the long run. In management’s words, “The potential impact of sequestration would reduce 2013 net sales by approximately $825 million.”
LMT’s stock price has however climbed ever since the sequester activation, and stands today at $126. Jim Simmons, Tom Russo, John Burbank, Ray Dalio and Steve Cohen predicted the rise in price and bought shares right after the new legislation came into place. However, they have been reducing their position by up to 75% or opting out of the business completely. I share the bearish feeling because future prospects for the firm are small to none due to its dependence on government contracts.
Customer Diversity and New Products
GD is a mid-size company, with a market cap of $29 million. The firm is a market leader in the aviation, combat vehicles, weapons systems and munitions, shipbuilding and marine systems, mission-critical information systems and technology segments. But, the company is comparatively less sensitive to the sequester than Lockheed Martin. That is, it holds a broader customer base. Additionally, some of its products are readily available for the civil and international market.
Prospects for GD are mixed. On the down side, the information systems and technology, marine systems, and combat systems segment will continue to struggle as the sequester remains in place. On the other hand, demand for Gulfstream aircraft remains strong across North America and the Asia-Pacific regions.
Growth is expected to continue being pushed by the latest product introductions: G650 and G280. The market impact of the first has set new standards on jet traveling, and the second is the biggest and fastest jet in its class. Currently, there is a five year backlog for that model alone, and demand for other models will rise as the economic environment continues to improve. However, that push may not be enough to offset government regulation, as backlog growth is flat for the last three years.
Financially, GD is strong, but an eye should be kept on razor-thin margins. Hence, management began to downsize operations in Europe and remove excess capacity. Gurus like Steven Cohen, James Barrow and Richard Pzena have recently taken a strong position, but Jean-Marie Eveillard, Paul Tudor Jones, Ray Dalio and Warren Buffett have all opted out. The new product introductions have given the firm some breath, but guru trades reflect that uncertainties over future prospects remain standing.
NOC is closer in size ($21 million) to GD than to LMT. The firm is a global security leader that provides innovative systems, products and solutions in unmanned systems to government and commercial clients. With respect to the sequester, management said that no disruption or shutdown of significant programs resulted from a federal government debt ceiling breach.
Growth for NOC is secured amid the sequester in place. First, the company's products rank high among U.S. defense priorities because they require small capital investments, reduce personnel exposure and address new warfare tactics. Second, drones have shown great potential in the civil market, as new applications continue to be developed. To emphasize the point, Domino´s has successfully tested pizza delivery using a drone in the UK.
Potential applications were also identified for remote sensing, commercial aerial surveillance, domestic policing, and oil & gas exploration, among others activities. Experts agree the drone segment is the fastest growing within the aerospace industry, and a 40% growth is expected for this year alone. Growth is mainly pushed by civil demand for new applications.
Financially, NOC is strong, and operates one of the widest margins in the industry. I feel bullish about this stock because the company has curved government regulation. Also, no commercial restrictions and civil application of its products make for a good future. Unfortunately, only Jean-Marie Eveillard shares my opinion. Jeremy Grantham, John Burbank and Pioneer Investments have all sold out during the last six months.
NOC is the most promising stock because its products were not affected by the sequester. Also, the balance sheet is clean, and is fair priced. Most importantly, the firm holds a dominant position in the fastest growing segment, with a growing demand for civil applications and huge growth potential.
Disclosure: Vanina Egea holds no position in any stocks mentioned.
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