By Clay Dillow
January 18, 2014

A year ago, “sequestration” was an ominous word in defense circles as the industry braced for what promised to be drastic across-the-board cuts in federal spending. But with this week’s passage of the 2014 omnibus spending bill, everything looks — well, everything looks pretty much the same as usual. That might not sound like news, but for an industry expecting to absorb a major blow as the federal cash spigot tightened, maintaining the status quo is actually a win. It spells a much more promising year for the defense industry than many would have imagined just a few months ago.

“The net-net is that sequestration cuts didn’t hit, and that’s positive for defense, and it looks like everything’s moving forward,” says Bill Ruttenbur, a managing director at CRT Capital Group. Programs ranging from submarine procurement to the F-35 Joint Strike Fighter to controversial Air Force drone fleets remain virtually untouched this year and next.

The $1.01 trillion overall budget allots the Pentagon $487 billion for baseline spending, plus another $85 billion to fight the war in Afghanistan under what’s known as the Overseas Contingency Budget, or OCO. That’s nearly $5 billion more than the Pentagon asked for. The budget agreement reached last month required the Department of Defense to spread around $25 billion in cuts as part of the previously planned sequestration reductions for fiscal 2014, which includes a $5.3 billion cut in procurement spending (down to $92.8 billion). So military contractors lost a potential $5 billion in federal procurement funds. But the Pentagon also has roughly $5 billion extra in discretionary dollars to spend in its overseas war budget through the OCO.

This is good news for the manufacturers of military technologies. Planning for the sequester forced even the biggest players in the defense sector to prepare for lean times. With the harshest sequester cuts now softened, the industry is in a place where a budget that simply maintains the status quo is far better than what it was expecting.

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“I think once we had the budget deal established in December, it changed the slope of the sequester and how it would be implemented,” says Stern Agee Senior Research Analyst Peter Arment. “Meanwhile, many defense companies have been driving costs down in a full sequester environment.” Now contractors have a clear picture of funding levels for the next two years, and they (and the Pentagon) can plan for the future. Not to mention there’s additional dollars being thrown back into the budget via the sequester relief deal hammered out but Congress in last month. “I think the actual environment over the next 18 months for the large-cap defense guys is that cash flows are gong to remain very stable, and that allows them to continue to be more or less aggressive with their shareholder-enhancing activities, whether that’s increased buybacks or increased dividends,” Arment says.

Who won by not losing?

General Dynamics: Falls Church, Va.-based General Dynamics (GD) will receive $90 million to continue upgrading M1A2 tanks at its Ohio facility, saving that program from the Pentagon’s chopping block. The bill also provides for $1.2 billion for the procurement of Virginia-class submarines, built by General Dynamics alongside Newport News, Va.-based Huntington Ingalls Industries (HII) at a rate of two per year. Further, General Dynamics will receive an additional $45 million beyond the Pentagon’s funding request for Stryker combat vehicles, pushing the total funding for that program to roughly $420 million.

Lockheed Martin: Lockheed Martin’s (LMT) $400 billion F-35 Joint Strike Fighter program — easily the military’s most expensive weapons program — was never in jeopardy of being scrapped, but the troubled F-35 Lightning II aircraft has its share of critics, and numbers could’ve been curtailed. The omnibus bill dictates that the F-35 program will proceed as planned, funding all 29 F-35s ordered by the Pentagon for 2014 and 39 of the next-generation strike fighters for 2015. That’s three fewer than the 42 the Pentagon wanted in 2015, but those aircraft will be made up later, maintaining the overall order at 2,443 aircraft.

Lockheed also gets a piece of a $333.5 million dollar contract to build the Air Force a new search and rescue helicopter in a joint venture with Sikorsky.

Northrop Grumman: The Air Force says it doesn’t need its fleet of Northrop Grumman Global Hawk surveillance drones (likely due to the emergence of faster, stealthier, classified unmanned surveillance aircraft). The omnibus bill says otherwise, barring the Air Force from retiring the fleet. Northrop Grumman (NOC) is also one of the contractors working on the Navy’s Littoral Combat Ship program, which saw $34 million slashed from its research budget but survived otherwise unscathed (the two primary contractors on that program are Lockheed Martin and Australian shipbuilder Austal).

(One loser in the omnibus bill: The Army’s Ground Combat Vehicle program, which was initiated to replace the overland force’s Bradley Fighting Vehicle with a 21st-century armored troop carrier. Congress only allotted $100 million of the $500 million the Army asked for in the new spending package — enough, Pentagon-watchers say, to start winding the program down. General Dynamics and BAE Systems (BAESY) are competing for the program which was expected to eventually cost as much as $36 billion.)

All this paints a fairly optimistic if predictable picture for Big Defense through 2014. The variables: classified budgets and international business, which can impact bottom lines. But as Arment notes, there’s a backdrop of steady cash flows in the domestic market that should keep things on a pretty even keel. For what it’s worth, the market seems to feel pretty good about defense right now. Lockheed Martin, General Dynamics, Northrop Grumman, and missile and defense component-maker Raytheon (it makes the Tomahawk cruise missile) have all been variously upgraded or had their price targets revised upward in recent weeks. General Dynamics hit its 52-week high this month. Raytheon (RTN) hit a lifetime high earlier this week.

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