Monday, April 01, 2013

What Defense Investors Should Know About Sequestration

It’s on the tip of practically every tongue in America right now.  Sequestration, the across-the-board government spending cuts outlined in The Budget Control Act of 2011 in order to offset U.S. debt ceiling increases.  Under the terms of the act the 2013 defense budget is to be reduced by $54.7 billion.  While that’s certainly a considerable sum, it’s not as bad as it sounds when you look at the larger picture.   

The initial defense budget for 2013 is $728 billion.  Therefore, sequestration should reduce the defense budget to $673.3 billion, or approximately the same amount as in 2007.  That’s still a sizable amount of money that defense contractors will be receiving.  The five largest defense contractors, Lockheed Martin (LMT), Boeing (BA), Northrop Grumman (NOC), General Dynamics (GD), and Raytheon (RTN), have had a combined sales of approximately $160 billion each year for the past four years.  They will certainly be affected and there are sure to be some bumps in their balance sheets but they aren’t likely to be very serious.

On top of that, these companies aren’t exactly small.  These defense contractors are powerhouse companies, capable of weathering the proverbial storm in revenue fluctuations.  Defense companies aren’t generally considered big movers on Wall-Street.  They are typically slow and steady, which is part of why they are attractive to investors.  

Another reason investors are drawn to defense contractors is because of the dividend payouts.  Dividends are paid from company profits, the money that is left over after paying expenses and taxes.  So, in theory if a contractor experiences a drop in profits as a result of the spending cuts their dividend payout might be affected, but it’s likely to be minimal, if at all.  Most defense companies pay dividends at a low ratio, no more than 50%.  That means their current dividend payments are likely to be sustainable, even if they take a hit to their profitability.

The last thing to be aware of is the process through which defense companies are paid.  It can literally take years for a company to be awarded a contract, have funding approved, and receive payment.  Sequestration doesn’t affect the money that has already been approved.  Therefore the full impact on defense contractors likely won’t be felt for a few years.

What does all of this mean to investors?  If you currently own stock in a defense contractor you most likely have nothing to worry about.  If you don’t currently own defense stock, now might be a good time to visit the idea since many skittish investors have sold their shares lately, driving the prices down. 

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