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Projected Defense Spending Cuts in Context

The U.S. will continue to spend large sums of money even with projected cuts.

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Department of Defense Budget History
The United States government has materially increased spending on defense during the last 20 years, with the bulk driven by conflicts in the Middle East that started in 2003. The 2000s decade was a golden age for defense contractors, as the total budget increased by an average 8.8% per year, and the portion spent on line items that we believe are heavily tied to the defense industry increased at a faster 9.5%.

We expect to see a slowdown in spending during the current decade that could average minus 1% for the overall budget and minus 3% for line items heavily tied to the defense industry. However, spending remains at a high level in total dollars. The chart below shows a historical view of the total defense budget, including our base estimate through 2022.

The budget more than doubled during the 2000s from the level in the 1990s. In fact, the Department of Defense spent nearly $5 trillion from fiscal 2002 through fiscal 2010, as compared to $2.7 trillion during the 1990s. Overseas Contingency Operations (OCO) started following the initiation of the Iraqi conflict in early 2003 and provided a nice tailwind during the 2000s. The total sum of OCO from 2002 through 2010 was more than $1 trillion (21% of total DoD spending). With the winding down of military operations in the Middle East, we expect this to decline to zero over the next several years.

Beyond a slowing in the overall budget resulting from proposed cuts, we believe the defense industry will be affected to a greater degree because personnel costs are unlikely to be cut. We have assumed 3% growth for personnel costs annually, adjusted for estimated troop levels as proposed in the fiscal year 2012 defense budget. The chart below depicts the composition of the budget by three areas: personnel; operations and maintenance, procurement, RDT&E; and other. We believe the second portion, which is most closely tied to the defense industry's revenue potential, will be shrinking as a total proportion of the pie as personnel costs continue to grow over the next 10 years.

Stock Commentary
The remaining months of 2011 should bring increased uncertainty to defense companies as members of Congress meet and discuss ways to tackle budget deficits. The recent contentious disagreements that played out during the summer months are likely to continue, and we expect proposed budget cuts will come down to the wire toward December 2011. The increased uncertainty does not bode well for companies in our coverage universe. Still, should the market sell these stocks to levels that discount the worst-case scenarios, we may recommend purchase for long-term investors.

We summarize our updated fair values after incorporating the new budget realities in the table below. Among the five prime contractors-- Lockheed Martin (LMT),  Boeing (BA),  General Dynamics (GD),  Northrop Grumman (NOC), and  Raytheon (RTN)--we think Boeing and General Dynamics offer the most downside protection at current prices. We also like  Rockwell Collins (COL).  Textron (TXT) appears the cheapest, but its uncertainty rating is very high.

Neal Dihora does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.