Fearing ‘fiscal cliff,’ investors bearish about U.S. contractors

July 15, 2012

Investors are punishing companies that depend on the U.S. government for sales as contractors face as much as $1 trillion in Pentagon cuts because Congress and the White House haven’t agreed on a deficit-reduction plan.

A Bloomberg index of 70 federal contractors fell 15 percent for the 12 months ended July 3, compared with a 2.7 percent gain in the Standard & Poor’s 500-stock index. Alliant Techsystems, the Defense Department’s biggest ammunition producer, and AAR, an aviation parts supplier, were among the biggest losers.

The contractors’ performance deteriorated relative to the S&P since March 1 amid rising investor concern that a “fiscal cliff” of possible spending cuts and tax increases tied to the deficit standoff will hurt government vendors’ earnings the most.

“There aren’t many bull scenarios for the prime contractors,’’ said George Ferguson, a defense analyst at Bloomberg Industries in Skillman, N.J. “The market is reluctant to put money to work in the space.’’

The Pentagon, the nation’s biggest buyer, awarded $375 billion in contracts during the year ended Sept. 30, or 70 percent of the $535 billion government-wide total, according to data compiled by Bloomberg.

Contractors face the possibility of $500 billion in defense cuts scheduled to begin Jan. 2 unless Congress acts. The cuts are part of $1.2 trillion in automatic reductions to domestic and national security programs that were imposed after talks failed last year on a plan to curb the nation’s deficit.

The reductions would come in addition to $487 billion in defense cuts over 10 years, which the Obama administration announced last year.

Whether the two parties can agree on a pact that reduces or delays the Pentagon cuts isn’t clear, especially after attempts at deals failed in 2011, said Michael Lewis, a defense analyst at Lazard Capital Markets in New York.

“Investors should look at this sequestration as a real threat,’’ Lewis said. “I have limited confidence that anything will get done.’’

The gap in the performance of the Bloomberg contractor index and the S&P has widened as the deadline approaches. The performance of the group of contractors since July 5, 2011, lagged behind the S&P by 10.7 percentage points as of March 1. By July 3, the gap was 17.7 percentage points.

Arlington-based Alliant has dropped 29 percent during the past year, while AAR, based in Wood Dale, Ill., is down 50 percent. ManTech International, a Fairfax-based provider of technology services to the Defense Department, has declined 46 percent.

The Bloomberg index of 70 contractors comprises defense companies such as Lockheed Martin and Raytheon that receive at least 3.5 percent of revenue from the U.S. government. It also includes health-care providers Humana and Health Net, as well as drug distributor McKesson and pharmaceutical maker Merck.

Even if the cuts are avoided, an agreement will probably be reached to further cut defense spending to reduce the deficit, Ferguson said.

“There seems to be no possible way that the top line of the defense budget is going to grow,’’ he said. “Investors are finding it difficult to take a bullish long-term view on the sector.’’

— Bloomberg News

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