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A New Direction for Defense Spending?

We see little change from the current strategy.

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U.S. defense spending has generally declined as a percentage of total government spending as well as GDP over the past 60 years. Large spending spikes that occurred during World War I, World War II, and the Korean War were followed by more aggressive cuts than those after Vietnam and the first Gulf War. In our historical analysis of defense spending, the government's willingness to spend when the nation is under threat is clear. More concerning of late is the inability of the government to make material cuts, even though cuts do occur. Based on our analysis of spending before and after the recent conflicts, our take is that deep cuts should not be expected.

On Jan. 5, President Barack Obama announced the results of the first strategic review undertaken by Secretary of Defense Leon Panetta. The study outlines missions that the military should be able to execute and principles for attaining success. The president said the base defense budget will continue to grow even while meeting the cost-reduction requirements outlined in the Budget Control Act of 2011. However, his budget will probably exclude the sequestration cuts implied by the failure of the supercommittee in 2011. Nonetheless, our base-case scenario over the next five years still calls for reductions of 3% to the overall Defense Department budget and 5% to items more relevant to the defense industry as it includes reductions in overseas contingency operations along with cuts mandated by BCA 2011 and a portion of cuts from sequestration.

The president's updated strategy is broadly similar to the current strategy of doing more with less, in our opinion. We expect defense to be a big talking point in this election year, but do not believe draconian cuts (significantly more than our adverse scenario of $950 billion over 10 years) are in the pipeline. The largest issue in our fair value estimates for the defense companies we follow-- Lockheed Martin (LMT),  Boeing (BA),  General Dynamics (GD),  Northrop Grumman (NOC),  Raytheon (RTN),   L-3 Communications (LLL),  Harris (HRS),  Rockwell Collins (COL),  Alliant Techsystems (ATK), and  SAIC (SAI)--is the uncertainty surrounding the maintenance of operating margins. We would adjust our fair value estimates should our views on the industry's ability to manage margins changes materially.

Secretary Panetta outlined a slew of missions that he believes the military should be able to complete even in the face of slowing budget growth. Following are what we believe to be the important ones, accompanied by our short interpretations of what we think they mean.

Counterterrorism and irregular warfare and operating effectively in cyberspace and space. The Department of Defense will increase spending on intelligence, surveillance and reconnaissance, unmanned aerial vehicles, and satellites.

Projecting power despite anti-access/area denial challenges. DoD will increase spending on ISR, cyber, and space-based capabilities including satellites, submarines, missile defense, and a new stealth bomber.

Maintaining a safe, secure, and effective nuclear deterrent. DoD will use a reduction in nuclear weapons as an easy way to reduce spending and still project power.

Conducting stability and counterinsurgency operations. DoD would like to reduce the number of forces in Afghanistan. We estimate more forces in the Middle East somewhere, not necessarily just in Afghanistan.

Secretary Panetta also laid out principles for success; we highlight a few of them below.

Maintaining a broad array of military capabilities. DoD budget cuts aren't likely to be draconian, but measured.

Managing overall force. DoD will reduce personnel and increase technology.

Making the hard investment choices. The idea of reversibility was included, and we read this to represent any means by which the government could alter contracts with its providers. The government can cancel contracts at will, but we see this as a more aggressive posture. We will inquire more about this from our covered companies during and after the first-quarter earnings reporting season.

Reducing the cost of doing business. DoD desires to reduce the growth of compensation and health-care costs and cut Pentagon headquarters costs. For the defense industry, this is likely to mean more fixed-price contracts and lower-margin potential for suppliers. Health-care cost containment essentially comes down to asking our active servicemembers to pay more for their health care, and we don't know how politically viable that is.

Potential Budgets the President Could Propose
The president should be able to propose benign defense base budgets and still meet mandated cuts under BCA 2011. We use his proposed fiscal 2012 budget, which included explicit values for fiscal 2012 through fiscal 2016, and then use the final-year growth rate of 2.2% for the remaining years to arrive at the baseline budget that will be used for savings calculations. We use growth rates of 1.5%, 1%, and 0.5% from the fiscal 2012 base year to forecast budgets for 10 years and arrive at cumulative savings of $567 billion, $724 billion, and $877 billion, respectively. Two key values drive these results: One is the assumption of 2.2% baseline growth for the president's budget, and the other is using the actual fiscal 2012 approved value of $530 billion instead of the proposed $553 billion. However, even if we use a 2% growth rate and the original $553 billion for the base, the savings under the three scenarios are $290 billion, $453 billion, and $613 billion, respectively.

The president has the ability to "save" sufficient sums by simply reducing the rate of growth of DoD's base budget. The base budgets exclude overseas contingency operations, or OCO, which were approved at $115 billion for fiscal 2012, and the proposed fiscal 2013 budget will probably exclude sequestration cuts following the failure of the supercommittee. In reality, OCO is certain to decline for fiscal 2013 following the removal of troops from Iraq and the continued removal from Afghanistan. Analysts at think tanks have wondered whether the president or Congress would use OCO reductions as savings, a move that could easily meet sequestration requirements. Both OCO and sequestration cuts are likely to lead to real reductions in total defense spending, in line with our base-case scenario. Our point is that the president can deliver the mandated savings under BCA 2011 without actual declines in the base defense budget.

Implications for the Defense Industry
President Obama's updated strategy is broadly similar to the previous strategy, in our opinion. The upcoming fiscal 2013 defense budget proposal along with the program-by-program details will help us discern impacts to the defense industry players. Although we expect defense to be a big talking point in this election year, we do not think huge cuts are in the works.

Our historical analysis of defense spending leads us to expect a contraction in overall defense spending, as has happened following major conflicts in the past. This is consistent with our forecast of average annual cuts of 3% and 5% over the next five years to the overall DoD budget and items more relevant to the defense industry, respectively. There are also ways the president's budget proposal can meet certain savings targets by simply slowing the growth of the budget, without actually making cuts (consistent with our benign scenario). Nonetheless, we believe the market is currently discounting our base-case scenario or real defense spending cuts, not the president's slowing of the growth rate. Should Congress not authorize defense spending cuts in future years, as it did for fiscal 2012, we believe our covered companies could trade closer to our bull-case scenario. For now, however, we are making no changes to our fair value estimates.

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