The U.S. debt ceiling agreement signed into law Aug. 2 puts new pressure on defense companies, who will likely see shrinking profit margins over the next decade, and, in a worst-case scenario, a downgrade of their credit ratings, according to a new report from Moody's Investors Service.
"Defense contractors made a lot of money and generally enjoyed high credit ratings as defense spending ramped up every year during the past decade, but with much-talked-about government spending cuts potentially approaching $1 trillion or more, this will be a game-changer for the industry," the Aug. 10 report says.
Moody's had been expecting the defense base budget to plateau over the next 10 years, but the agreement reached last week "has placed defense (along with health care) at the center of the likely solution to the nation's persistent deficits and escalating debt burden," the report says.
And, because cuts to the defense budget will most likely hit procurement and R&D accounts the hardest, profit margins for big and small defense contractors alike could be squeezed.
It is possible the latest deal is only the jumping-off point for further negotiations and the beginning of a debate that could stretch over the next three years, Russell Solomon, senior vice president at Moody's, said.
It is an unlikely scenario, but it is possible that the cuts could go deeper than $1 trillion, he added.
If that happens, it may warrant consideration of downgrading some credit ratings in the sector.
On average, the defense sector enjoys profit margins averaging 10 percent, a level considered "relatively modest," by Moody's. Companies at similar rating levels normally have profit margins in the mid- to low-teens.
As defense contractors compete over a smaller pie, those already "modest" profit margins will shrink.
Lockheed Martin, the world's largest defense company, reported $2.93 billion in profits in 2010.
"Pressure on earnings and cash flow could eventually lead to ratings downgrades for some contractors, particularly given that these added pressures come as many still face substantial pension-funding needs," the report says.
It is our job to look at the ultra-conservative scenario and raise red flags for investors as they consider future investments, Solomon said. Rating downgrades are not imminent and remain unlikely, but "we're more concerned now than we were six months or a year ago," he said.
The report notes that when all is said and done, the U.S. defense budget will still remain at or near historically high levels.
And, "it will still exceed that of any other country by several multiples."
Concerns about jobs and American exports, as well as political pressure not to look soft on defense, could help counter calls for bigger cuts.
"Given that defense spending is currently very near historical highs, however, a scenario of deeper cuts would likely only just begin to more materially dampen real growth, rather than dramatically reduce total spending," the report says. "This is because the cuts would come off of the future-year budgets which have an inflationary element built in and consequently continue to grow every year."
This means that while the landscape is changing for defense companies, the defense budget may still grow, just more slowly than it has been.
In the meantime, companies will feel increasing pressure to deliver services on time and on or under budget.
"We believe the larger military programs are most vulnerable, particularly those that are behind schedule or over budget, and those with near-term expiration that are up for bid renewal," the report says.
For example, there is a strong chance that the F-35 Joint Strike Fighter buy will be reduced.
"This program is less at risk of outright cancellation, but it could easily be subject to further stretch-out, material reduction in the number of aircraft procured and/or cancellation of the more-expensive short take-off vertical landing variant in development for the U.S. Marine Corps," the report says.
Moody's also ranks the V-22 Osprey and the Navy's Littoral Combat Ship at moderate risk for reduced buys.
Plus, the government will continue to shift risk toward the contractor through increased use of fixed-price contracts.
Companies whose sales are predominantly to the U.S. government are most exposed. However, even companies with revenue streams coming from other regions are also highly exposed because many European countries are facing the same budgetary pressures as the United States. This includes companies like BAE Systems, Thales and Finmeccanica.
Other companies, like Boeing and Textron, mitigate their exposure to defense spending pressures through their commercial operations, according to Moody's.
Unmanned aviation, cyber security and C4ISR are identified as high priority areas for future spending. Expect to see companies scale up in these areas, the report says.