Harsh new realities for the military industrial complexSeptember 12, 2011: 1:46 PM ET
Defense contractors are bracing for more cuts from the newly formed debt super committee.
By Cyrus Sanati, contributor
FORTUNE -- Congress has reconvened, which means lobbyists for the powerful defense industry will go into overdrive to stave off what some in the industry believe could be the greatest single threat to the military-industrial complex since the end of the cold war: The bipartisan budget-cutting "super committee." Given the acrimony in Washington between Republicans and Democrats, the stage is set for automatic cuts that could see the defense budget fall precipitously, potentially crushing the profits of some of the nation's largest military contractors.
The industry is bracing for the worst, and it's responding by shifting its focus to foreign markets and high-tech automated weapon systems. Such moves will serve as a stopgap measure for now, but the budget shortfall could result in even deeper cuts in the near future. Any such cuts will most likely fall disproportionately on the military contractors, potentially compromising the nation's military readiness.
You know things have gotten bad in Washington when the defense budget goes on the chopping block. The budget deal reached between both parties this summer forced the military to swallow $350 billion in cuts over the next decade. The cuts, which will go into effect in fiscal 2012, lower the annual military budget by around $35 billion to $50 billion a year – or around 6% to 8% of the military's $570 billion projected budget for fiscal 2013.
And that might just be the beginning. Last week, the budget-cutting "super committee" of six Democrats and six Republicans from the House and Senate held its first meeting. They are tasked to find $1.2 trillion in savings over the next decade. If they fail to do so by Thanksgiving, which seems likely given how partisan Congress has become these days, automatic spending cuts of at least $1.2 trillion would be set in motion, $600 billion of which will come right off the defense budget. This would potentially lower the projected 2013 defense budget by 16% to $472 billion.
Congress will decide, in consultation with the military, what will be cut. Military contractors are worried that the cuts will fall disproportionately on them since it's easier for politicians and the military bureaucracy to cut an expensive new project than to "fire" a soldier or shut down a base. Deutsche Bank analysts project that as much as 50% of the cuts will likely spread through the weapons spending accounts, despite the fact that they make up just a third of the overall defense budget.
You'll find very few in the Pentagon shedding a tear for the contractors. The military industrial complex has had a field day since 2001. The pumped up defense budgets, coupled with the additional $120 billion a year in spending for the wars, have been a boon for the defense industry. Profits at the big five U.S.-based defense contractors -- Lockheed Martin (LMT), Boeing (BA), Northrop Grumman (NOC), General Dynamics (GD) and Raytheon (RTN) -- grew from $6.7 billion in 2001 to $24.8 billion in 2010. Profits grew twice as fast as revenue.
And it's not just the pure-play defense contractors who cleaned up. Large conglomerates, like General Electric (GE), foreign defense firms, like BAE systems, and large construction firms, like KBR (KBR), also saw their profits jump significantly during that time thanks to all the defense spending.
Wall Street has rewarded the industry. Defense companies in the S&P 500 have seen their stock prices soar 67% in the last decade, while most other industries are flat or up just a few percentage points.
But stock prices have started to come down on anticipation of the spending cuts. During the last downturn in defense spending, which lasted from 1985-1997, stock prices for defense firms fell 33%, according to RBC Capital Markets. Northrop Grumman has already seen its stock price fall 25% since July on anticipation of harsh cuts, forcing it to announce layoffs. Lockheed Martin's stock is down 10% since July and it has cut nearly 4,000 jobs this year in anticipation of the budget cuts.
Fighter jet cuts?
The defense appropriations committee will sit down this month to discuss how they will make the annual $35 billion to $50 billion in cuts already approved in the budget compromise. Talk on the Hill suggests that three major weapons projects, the next generation F-35 fighter jet, the V-22 Osprey Helicopter and several new tactical ground vehicle programs, will be hit hard.
The fighter jet program is in the committee's sights because of its size -- $385 billion, which is up from original estimates of $233 billion, making it the costliest defense project ever. The program, which is headed up by Lockheed Martin, supported primarily by Northrop Grumman, BAE Systems and United Technologies (UTX), could cost the U.S. military upwards of $1 trillion over the next 50 years in procurement and support, according to some estimates. Lockheed Martin seems to be the most vulnerable with around 40% of the contractor's total operating profit for the first six months of the year, $731 million, deriving from the F-35 program.
In addition to the F-35, there's discussion to completely eliminate the $40 billion Ground Combat Vehicle and Joint Light Tactical Vehicle projects, which are meant to replace the Army's aging fleet of armored fighting vehicles and Humvees. Both programs are in the design phase, with Lockheed Martin, General Dynamics (GD) and BAE Systems each jockeying for the contract. Other tactical wheeled programs, like the ones supported by Oshkosh Defense, are also thought to be on the chopping block.
Sacred cows on the chopping block
A whole host of other projects could be on the cutting board if the special committee fails to eliminate $1.2 trillion in spending. The military is currently modeling out what programs that would need to go if it is forced to find another $600 billion in savings over the next 10 years. The F-35 program could be eliminated completely along with research for projects that have had questionable success, like the much-maligned anti-ballistic missile program (Star Wars). Moody's believes that Lockheed Martin could take another hit with the cancellation of the Navy's $34 billion Littoral Combat Ship, which has been mired with delays and cost overruns. Boeing could see delays in its newly won $35 billion KC-X refueling tanker project.
But the military cannot eliminate all its new weapon systems if it intends to be a formidable fighting force. Further cuts in the budget will force the military to take a hard look at some of its sacred cows, starting with its generous benefits for soldiers. At the top of the list is the need to revamp the military pension scheme, which allows service members to start collecting half of their salary for life the day after they serve for 20 years. The military pension scheme is a time bomb waiting to go off. The future pension liability will grow from $1.3 trillion this year to $2.7 trillion by 2034, according to a study by the Defense Business Board. They recommend moving the military from a pension scheme to a 401(k)-type defined contribution benefit plan. That could see more money move into the markets, which may be a boon for Wall Street money managers.
The elimination of soldiers and bases will also need to be looked at if the military is forced to comply with the cuts. The Secretary of Defense said in January that the Army would eliminate 27,000 uniformed personnel starting in 2015, while the Marines may lose 20,000 troops. The deeper cuts may force the military to up their timeline and cut even more personnel.
The elimination of just 10,000 non-deployed uniformed personnel would save the US around $1 billion a year, according to the Office of Management and Budget. The number is so high because the military feeds, clothes and houses its personnel. They also pay well -- military personnel now earn more than their civilian counterparts with the same education level.
Moody's believes that some of the cuts in the big weapons programs will be offset by increases in spending for cyber security and unmanned aircraft. Companies that could benefit include General Atomic and Northrop Grumman. But drones are relatively cheap, with the global market for unmanned aircraft over the coming decade projected to be worth just $11 billion, according to the Teal Group.
One way the defense industry could recover would be to find new markets for their weapons. But selling military equipment to other countries is fraught with political pitfalls. A contract to sell some $8 billion worth of F-16 fighter jets to Taiwan has been snarled in Congress for months over concerns that it could anger the Chinese government, while the potential sale of Northrop Grumman's Global Hawk spy planes to South Korea would require the U.S. to obtain a waiver to a complicated arms treaty.
The defense cuts could prompt Congress to allow more foreign military sales, but it is unclear if that could fill the gap. Defense contractors will just have to slim down in this new environment of budget cutting, something many of them haven't done in decades.