The defense industry has been warning about the effects of the coming fiscal cliff for several months now. If Congress fails to come to a resolution on how the U.S. will begin to solve its fiscal deficit troubles, an automatic cut (or sequestration) of $50 billion in U.S. defense spending will take effect on January 2, 2013.

In a new report from Moody’s Investor Service, the ratings firm says that a cutback that severe is essentially equivalent to eliminating a defense contractor the size of Lockheed Martin Corp. (NYSE: LMT), which employs more than 123,000 people. The spending cut is also comparable to losing one and a half times the revenues of Boeing Co.’s (NYSE: BA) defense business or the combined revenues of Northrop Grumman Corp. (NYSE: NOC) and Raytheon Co. (NYSE: RTN).

Global defense spending is projected to fall 5% to 10% in 2013 according to Moody’s. To combat the decline, the ratings firm suggests four possible scenarios. In the first, large, top-tier companies will merge. Given the collapse of the proposed merger between BAE Systems and EADS, Moody’s doesn’t put a lot of stock in this option:

[W]e believe that the hurdles that would need to be scaled with governments on both sides of the Atlantic make prospects for any such deals to emerge in the near term relatively low.

A second scenario envisions mergers between second- and third-tier suppliers, and Moody’s rates the chances of such transactions as “high.”

A third scenario suggests that the top-tier players will acquire the smaller companies, but Moody’s does not see “widespread activity” in this area unless specific capabilities such as cyber-security become attractive to the big guys.

The fourth scenario involves spin-offs of underperforming units of the large defense companies, and Moody’s points to several of these kinds of transactions in the past few years. The ratings agency considers the likelihood of spin-offs and sales transactions to be “high,” particularly those that rely on supporting troop deployments.

Shares of both Lockheed and Northrop Grumman are within spitting distance of 52-week highs set within the last couple of months. Raytheon’s shares posted a new high last month, but has given back about 5% of the gains since then. Another large defense contractor, General Dynamics Inc. (NYSE: GD) has been a laggard for the past six months, losing about 5% of its share price.

Even if Congress reaches an agreement on avoiding the fiscal cliff, defense spending is not likely to grow except in a few countries where U.S. firms are unlikely to be able to follow. Russia and China pop immediately to mind. That doesn’t mean that share prices on the big defense firms won’t pop if the cliff is avoided. But it could mean that any gains are likely to be short-lived.

Paul Ausick

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