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How Will Defense Contractors Fare Amid Budget Cuts?

None will be able to dodge the spending cuts, but some may be impacted less than others, says Morningstar senior credit analyst Rick Tauber.

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Jeremy Glaser: For Morningstar, I'm Jeremy Glaser.

We've heard a lot about defense cuts recently, and I'm here today with Rick Tauber, he's a senior credit analyst for Morningstar, to see how it's going to impact the defense contractors and what it's going to mean for their creditworthiness.

Rick, thanks for joining me today.

Rick Tauber: How are you doing, Jeremy?

Glaser: Good. So, let's talk a little bit about defense cuts. We've heard a lot about a potentially leaner military, trying to get some budget deficit reduction from military spending. What are you seeing? What do you think are some of the potential outcomes for spending?

Tauber: Well, just to take a step back, the Budget Control Act of 2011 was passed in August to allow the debt ceiling to increase, and that is mandating about $450 billion in defense spending cuts over a 10-year time period beginning in 2013. This was followed by the creation of the Super Committee, which was mandated to cut another $1.5 billion of spending, which they failed to do and resulted in sequestration, which is another automatic $1.2 billion of cuts, about half of which is going to come out of the Department of Defense. So that's kind of the backdrop, and basically off of this, we built three scenarios to look at how these cuts are going to impact our credits.

Glaser: So if you look at the cuts, there's certainly some winners or losers on the defense side. Are there some areas that you think are going to get hit a lot harder, or are there some areas that are going to continue to be pretty fully funded?

Tauber: Well, to be honest, Jeremy, we think everybody is going to be a loser in the space. We don't think anybody is going to be able to dodge these cuts in one way or another.

Now within our coverage list of the eight companies we follow on the credit side, the actual winners overall are going to be the companies leveraged to the aerospace cycle, which has a strong outlook, which will more than offset defense cuts.

Within defense we think that the companies that may be impacted less are the ones that might have some of the longer-cycle programs like shipbuilding or some of the long-term fighter contracts and whatnot. And the other companies that might have greater risk have the shorter-cycle contracts, such as IT spending and such, which would include names like SAIC, L3, and Raytheon.

Glaser: So taking a look at some of those individual names, and thinking about the creditworthiness, have you really changed your credit rating on a lot of these companies because of these changes?

Tauber: As part of the comprehensive overview, and as a result of the planned spending cuts, we looked at each credit, and did a mass downgrade of the sector, with only Rockwell Collins and Boeing maintaining their credit ratings, given their aerospace exposure and really a more positive overall credit outlook.

So, the rest of the sector we downgraded--the other six names--one to two notches.

Glaser: So, are they now getting into riskier territory, or are they still relatively strong credits, but just not quite as strong as they were before the cuts?

Tauber: Good question. One thing I'd point to is, even with these cuts on the horizon, each of these companies generates very impressive amount of cash flow, typically in the 25% to 50% free cash flow-to-debt ratio.

So, I think all of these companies really control their ratings destiny. They can use that free cash flow to address debt maturities or pension obligations, if they want to. The risk is that we've seen a lot of these companies focus on shareholder-friendly activities. So, share repurchases, dividends, and to some degree acquisitions, and this becomes the risk that ratings could potentially go farther down from here on many of these names.

Glaser: So, for an investor looking to get into the credit space in defense, what names should they be looking at? What looks attractive right now?

Tauber: Well, our one overweight in the sector right now is actually L-3 Communications, which is also our weakest-rated credit at BBB-. And the key here is that we think management is very focused on their investment-grade ratings. We have the same rating as the NRSROs. In fact, they are the only ones that actually told us that they're going to pay down debt in 2012 to manage their leverage ratios. So these bonds, we think, are trading appropriately for a weak BBB credit but give you a lot of additional spread relative to the rest of the group.

If you look at the weak A, high BBB type credits here, you're picking up around 150 to 175 basis points to trade down to an L-3 from, say, a Lockheed or a Northrop or SAIC, all of which we have at market-weight. But we think depending on how companies manage themselves and over the time period as these cuts play through, they might potentially have some downside risk.

On the other hand, looking at the highest quality, Rockwell Collins and General Dynamics both warrant our highest rating at A--but again, Rockwell Collins being leveraged to the aerospace side of the business, we think has a positive fundamental credit outlook. GD, while they do have the Gulfstream unit and is launching a new aircraft here, we think has more downside risk than Rockwell Collins, and you get similar spreads on Rockwell to GD. So, we like Rockwell as the highest-quality name.

Boeing, we rate a notch lower at A-. It also has some positive fundamentals now with the deliveries of the 787 set to ramp up, but we just think Boeing trades too rich; they trade moderately inside of Rockwell Collins, for example. So, we maintain an underweight on that name.

Glaser: Rick, thank you so much for your thoughts today.

Tauber: You bet.

Glaser: For Morningstar, I am Jeremy Glaser.

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