For the makers of the military's ships and fighter jets, the boom times may be coming to an end. At least that's what some Wall Street analysts and recently sluggish defense contractor stock prices suggest.
In the face of a stubborn budget deficit fed by hurricane relief bills and rising war costs, the surge in defense spending following the Sept. 11, 2001, terrorist attacks is likely to level off, experts say. The signs are plentiful.
Gordon England, the acting deputy secretary of defense, has ordered the military leadership to find $32.1 billion in budget savings over the next five years, and Gen. T. Michael Moseley, the Air Force chief of staff, has warned that programs with significant cost growth risk being canceled. The Pentagon also is awaiting completion of a department-wide reassessment of missions, weapons and force that could recommend further changes.
This has created a sense of anxiety within the defense industry. The stock of Lockheed Martin Corp., the Pentagon's largest contractor, is down 5 percent since August, despite a third-quarter profit of $427 million. Shares of Northrop Grumman Corp., the maker of submarines and satellites, have stayed flat despite a profit of $293 million during its last quarter.
To be sure, any cuts are expected to be spread over several years, and heading into the mid-term elections Congress may be reluctant to significantly scale back spending, industry analysts said. Just yesterday, the Senate approved a measure to buy more C-17 transport planes, although the Pentagon has indicated it plans to stop ordering them.
Still, some analysts feel the slump in investor enthusiasm could soon trickle down to the usually buoyant stocks of the industry's small to mid-size players. Many of the firms specializing in information technology and electronics continue to have "premium valuations" that are "unwarranted," Joseph B. Nadol, aerospace and defense analyst for J.P. Morgan, said in a recent note to clients. "As we believe defense growth will slow to near-zero in 2007, we do not believe these companies will sustain the double-digit top line growth that their managements and investors are targeting," the report said.
Even with cuts, defense spending will not fall to the low levels that followed the end of the Cold War, said Michael E. O'Hanlon, a senior fellow of foreign policy studies at the Brookings Institution. The proposed reductions "are not all that bad," he said. "So, you know, I am not crying too many tears for them."
Spokesmen from Bethesda-based Lockheed, Northrop Grumman Corp. of Los Angeles, Raytheon Corp., Boeing Co. and General Dynamics Corp. of Falls Church -- the largest defense companies in the country -- declined to comment on potential cuts to the budget.
During a conference call with analysts last month, Northrop's chief executive, Ronald D. Sugar, summed up the industry's sentiment about the 2007 budget, which isn't scheduled to be submitted until February but has already started to worry Wall Street. Asked what the company expected, Sugar said, "That's, of course, the $64,000 question at this moment in time as we're all watching for the smoke to come [out of] the buildings in Washington."
"We're now in the cost-cutting drill that happens every year at this time," Nicholas D. Chabraja, chairman of General Dynamics Corp., said in a similar call with analysts. "And you can't in the fall of the year find any human being alive, either in Congress or up in the Pentagon, who will tell you there will be an increase in defense spending."
Despite the expected slowdown, "we are not thinking we will see the bottom fall out of the defense budget," said John W. Douglass, president and chief executive of the Aerospace Industries Association, a lobby group. But "there is worry because these are uncertain times," he said. "The road ahead in defense is a lot less clear, because no one knows how much longer we're going to be in Iraq and Afghanistan. That clouds the picture quite a bit."
The past four years have been a boom time for defense contractors. Companies that produce bullets and repair equipment enjoyed an increase in revenue because of the wars in Iraq and Afghanistan. At the same time, the Pentagon continued to spend billions of dollars developing large weapons. The Pentagon's procurement and research and development budgets, where major weapon systems get most of their funding, increased to $148 billion in fiscal 2005 from $103 billion in 2001, according to the fiscal 2006 budget proposal.
Revenue at Armor Holdings Inc., which puts armor on military vehicles, has increased from $197 million in 2001 to $979 million in 2004. Lockheed's revenue jumped from $23 billion in 2001 to $35 billion last year and is expected to reach $37 billion this year.
A shift began last year when the Pentagon proposed $30 billion in cuts over the next five years, including billions from Lockheed's F/A-22 Raptor fighter jet and Navy submarine programs. Congress balked at some of the proposed cuts, especially one to pare back Lockheed's C-130 transport planes.
Things could be different this year. This is the first time in years that both Democrats and Republicans on Capitol Hill have questioned defense spending priorities, said Pierre A. Chao, director of defense industrial initiatives at the Center for Strategic and International Studies. "Within the overall political context, it is more likely that the cuts that the administration proposes will stick," Chao said.
Air Force leaders have decided that they do not need as many of the F-35 fighters as current plans require and cannot afford to buy more C-17s even though they want them, said Loren B. Thompson of the Lexington Institute, a think tank that studies defense issues.
"The big issue for the defense industry is not the budget cuts, but the way money is being reallocated away from weapons," Thompson said. "More money is going to health care and fuel costs and support services that have nothing to do with defense industry profits."
Some defense contractors have prepared for a slowdown in Pentagon spending for some time by diversifying into nontraditional services like information technology. Lockheed, for example, has expressed interest in buying the government business of Computer Sciences Corp., which would extend its lead in the federal information technology market.
"The expectation was that the budget would level out," said Philip Finnegan, director of corporate analysis at the Teal Group. "It's just happening more quickly than they were expecting."
C-17 TRANSPORT PLANE: Boeing | F/A-22 RAPTOR FIGHTER PLANE: Lockheed Martin
F-35 JOINT STRIKE FIGHTER: Lockheed Martin | DDX DESTROYER: Northrop Grumman An Air Force C-130J aircraft sits on the flight line at Little Rock Air Force Base. A year ago, Congress resisted proposed cuts to Lockheed's C-130 program.