Where US Federal Budget Cuts Will Hurt the Most (LMT, NOC, BA, RTN, SAI, GD, HPQ, LLL, BAH, KBR)

The US House-Senate budget reduction committee, or the ‘super committee’, that is charged with recommending $1.5 trillion in budget cuts over the next 10 years has just another 10 days to deliver its recommendations before automatic cuts of $1.2 trillion kick in. If the committee fails to agree on cuts, the automatic cuts fall equally among defense spending and a variety of programs that are together lumped under the heading discretionary spending.The discretionary spending cuts would likely come from federal programs that aid the poor, education, and the elderly.

No specific cuts have been identified in the legislation that created the super committee, but to achieve $600 billion in cuts over ten years is sure to cause some pain to a variety of constituencies. That amount is increased by the $350 billion in cuts already approved by Congress over the next ten years. Trying to discern where a publicly traded company might get hurt by impending cuts is, at this point, pretty much guesswork.

On the defense end, cuts are far more likely to have an effect on publicly traded companies that have significant federal defense contracts for everything from fighter planes to software. The following chart shows the top ten defense contractors in 2011, together with the total amount of their contracts, as derived from 2010 contract levels:

Privately held DynCorp International Inc. falls just above H-P, at $2.4 billion. Excluding DynCorp, the top ten contractors are slated to post sales of $47.6 billion in federal contracts in 2011. The top ten in 2010 posted sales of $68.2 billion. So far in 2011, a total of more than $196 billion in defense contracts have been awarded. The total in 2010 reached $247 billion, and that number is almost surely out of reach for this year.

Cuts to defense spending have already begun, as the US winds down its presence in Iraq and prepares to do the same in Afghanistan. Not including the wars in Iraq and Afghanistan, the Pentagon budget for 2011 reached nearly $550 billion.

If the super committee doesn’t reach agreement, the defense budget faces an automatic cut of $60 billion. Not all  will come from personnel reductions or from cuts to defense contracts. Assuming, however, that the US military is more willing to give up programs and keep people, the chop on defense contract spending could really hurt a few companies.

An analysis by Credit Suisse suggests that Lockheed Martin and L-3 Communications are especially exposed to cuts in the defense budget, while Raytheon and Boeing are least exposed. Lockheed’s F-35 fighter plane almost surely faces cuts and L-3 will suffer from troop drawdowns in Iraq and Afghanistan.

Raytheon is spared primarily because nearly 40% of its revenues come from overseas and from classified US contracts which are not subject to Congressional review. Boeing, which earlier this year won a contract to supply a new Air Force Tanker, also stands to lose less than many other defense contractors.

Share prices haven’t moved a lot for these defense contractors since the super committee meetings began either. Here’s a comparison of share prices on July 1st with closing prices on Friday:

Interestingly, the smallest share price drop is recorded at Lockheed, with Raytheon and Boeing still under -10%.  The sharp drop in H-P shares is probably more attributable to its leadership change than any impact from defense spending, but certainly if a sharp drop in spending occurs, replacing desktop computers and servers will feel a negative impact.

The share price drops at KBR, L-3, and SAIC are almost certainly tied to the withdrawal of US troops from Iraq and, ultimately Afghanistan. The effects of lowered defense spending here is easier to judge than it is in programs like the F-35, where even if defense spending is cut, the ultimate resolution may still be argued for months or years.

If the super committee fails to reach an agreement in the next 10 days, defense stocks are very likely to take a hit. If the committee does reach an agreement, defense stocks are even more likely to take a hit.

Paul Ausick