News of U.S. Cuts Shakes Market Pentagon May Slash Up to $60B Over 6 Years

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News of U.S. Cuts Shakes Market
Pentagon May Slash Up to $60B Over 6 Years

VAGO MURADIAN, Defense News, Jan. 4 2005

Uit het 'geruchtencircuit' ditmaal een bericht uit DefenseNews van deze week dat juist wijst op krimp in de F/A-22 Raptor vloot en niet de JSF in de Amerikaanse defensiebegrotingsvoorstellen. Vooralsnog blijft is het wachten op de definitieve bekendmaking van de begrotingsvoorstellen begin februari. Maar ook daarna zal het laatste woord over de grootte van de JSF vloot nog lang niet zijn gevallen. Om met een van de geciteerden hieronder te spreken: "Hold on, this is only round one". FS

News reports that the Pentagon has decided to halve its planned purchaseof F/A-22 Raptor fighters may discourage investors, already nervous aboutexpected U.S. procurement cuts, from buying defense and aerospace stocks through 2005, according to analysts and investors. Defense Departmentofficials remain tight-lipped about the future of the F/A-22, but many observers believe the stealthy fighter is just one of several programs on the chopping block as Pentagon budgeteers seek to slash between $50 billion and $60 billion from military spending during the next six years. The bulk of the cuts are to come from investment accounts. "We had Crusader and Comanche, and now we have F/A-22, so there's clearly a pattern emerging here," said Byron Callan of Merrill Lynch.
"At some point the light bulb goes off. Large, next-generation platform programs are getting shellacked." The Bush administration has already killed scores of programs in the name of transformation, including the $16 billion Crusader howitzer and the $38 billion Comanche chopper, even as defense budgets soared after the Sept. 11, 2001, attacks. Now, Iraq War costs and federal deficits are paving the way for more. The White House Office of Management and Budget has told the Defense Department to trim $10 billion from its budget for 2006, according to civilians with knowledge of the Raptor's budget. At least one of the Navy's 12 aircraft carriers is likely to be axed, and delays are envisioned for submarines, the future DD(X) destroyer, and the Air Force's Space-Based Radar and E-10 radar plane. Even missile defense, long an administration priority, may lose some planned funds. The multiservice F-35 Joint Strike Fighter, however, is to remain on track. Pentagon leaders have apparently vetoed an Air Force proposal to cut nearly one-third of its planned 1,763-plane purchase.
They are cutting the Raptor instead, over the protests of Air Force leaders weakened by the tanker procurement scandal. In general, Air Force and Navy programs seem likely to take more hits than Army and Marine Corps efforts, whose forces have been taxed hardest by the $4.9-billion-a-month Iraq occupation. DoD spokesman Eric Ruff declined to discuss the specifics of the 2006 budget. "The services are reviewing priorities and making decisions about where to make their investments," Ruff said. Because the specifics of the cuts are unknown, investors and analysts remainuncertain. As one senior industry executive put it, "There are two more significant factors here. One is the Hill and how they're going to react, and then the QDR," the 2005 Quadrennial Defense Review, now under construction and due out this year. "Hold on, this is only round one," the executive said.

Raptor Warning

The New York Times reported Dec. 29 that DoD officials had notified the White House of their decision to end F/A-22 production at about 175 of the planned run of 277 planes, which is made by a team led by Lockheed Martin and Boeing. The Air Force wanted 381. The F/A-22 was cleared last year fora limited production run of 83 jets. Nearly 30 have been delivered, and the first unit is to become operational at Langley Air Force Base, Va., in late 2005. "While we have not been notified of any changes to the F/A-22 program, if in fact these cuts do occur, they would not take place for several years and we believe that aircraft will prove its value and we hope to see their numbers restored," Lockheed spokesman Dennis Boxx said.
"The aircraft continues to perform well in testing and remains a top priority of the Air Force." Investors will now watch to see whether Congress will stave off the proposed F/A-22 cuts. One veteran analyst notes that programs can sometimes rally. "In the case of the F-15, the original number was 700, but 1,200 were bought. That could be the case with the F-22," said Joe Campbell of Lehman Brothers. "The Air Force might be willing to take a cut to the program knowing that once the plane is inservice, they will be able to get more." But Campbell, who was at theOffice of Management and Budget when the B-2 stealth bomber was launched, recalled that budget changes so buffeted that program the Air Force ultimately received just 21 aircraft for the amount of money intended to buy 132. Analysts do not agree on whether an F/A-22 cut would affect the per-plane price. Some say it could remain stable even if production is ended early, as long as production rates are kept about 24 planes a year. Others say it will break congressional cost caps.

Market Reaction

Defense stocks have been slumping since hitting an early December peak that prompted profit-taking. Lockheed stock, for example, hit its 2004 high on Dec. 3 at $61.62, short of its all-time high in early 2002. This was to be expected, said Heidi Wood of Morgan Stanley. "The markets move with such velocity that investors need to realize their profits much sooner; otherwise, they could lose them," Wood said. "With the sector up 32 percent year to date, it's natural to expect profit-taking. All these news events have only been excuses and catalysts, whether F-22 or budget cuts, to expedite a profit-taking process that was going to happen anyway.
"Now, if the overall economy doesn't take off, then these stocks are a value proposition and there could be a defense rally. Remember, this sector is the quintessential defensive investment play." Reaction to the Times story shaved stock values across the defense sector. On the New York Stock Exchange Dec. 29, Lockheed lost about 2.7 percent in heavy trading, closing at $55.25, while Boeing ended the day down 2.18 percent at $52.09, weighed down by slowing Chinese commercial jet orders. But investor reaction may have been muted because the F/A-22 report emerged amid the end-of-year holidays. "It's bad timing," one Wall Street analyst said. "First, most people are off. Second, even if they're in, they're not going to do anything rash now because you never make major moves this close to the end of the year because you can easily destroy your portfolio performance, and that's what your bonus is tied to. The real meaning of this is going to come when people get back from vacation." The F/A-22 newswas one more jolt to a market sector that has behaved oddly the past three years. "Right after 9/11, they had runup," said one investor, whorecently sold a chunk of Lockheed shares. "Then, when the procurement money and the outlays were coming on strong, people were down on the sector and values bottomed out. "They got hot before the election, but when people thought Kerry would win, there was a selloff and stocks weretrading at a discount on their multiple. Then Bush wins and people get euphoric because he's been strong on defense and we'd be in for four more years of growth. Then he talks deficits and program cuts."
Analysts had predicted for months that procurement would be cut after the November presidential election. But many investors were buoyed by reports that the administration would request between $60 billion and $100 billion in supplemental funding to cover Iraq war costs. "The market was betting that this rising tide would lift all boats," said Lehman's Campbell. "The concern always was whether the market was betting wrong. But decisions about 2009 and 2010 represent decisions when Secretary Rumsfeld won't besecretary and President Bush won't be president, so they are not really decisions at all." Still, it appears that cuts are on the menu. "What's clear is that it ain't going to get better from here," the Wall Street analyst said. "It's not like the Pentagon' s going to come out next yearand say, 'Well, actually, we're going to buy more of everything.' "

Lockheed Vulnerable?

Few of the market giants will suffer much from the loss of a single program, analysts say. Unlike the 1990s, when the Navy's cancellation of the F-14 program drove Grumman to merge with Northrop, industry consolidation has largely insulated the leading players from debilitatingblows. And the leading firms have been agile enough to chase shiftingopportunities. For example, Lockheed is going after a perceived Army truck market, using its systems integration and data handling capabilities to team with a British truck maker. Even delays and cancellations open opportunities to upgrade aging systems. But the Raptor cuts could hurt Lockheed, the biggest of the big guys. Development problems with both F/A-22 and F-35 already cut deeply into profits. Although the F/A-22accounts for just 5 percent of Lockheed's profits today, the firm counts on its fighter business, which also includes F-16 and F-35, for billions of dollars in sales. But Pierre Chao, senior fellow at the Center for Strategic and International Studies, Washington, who spent 10 years as a Wall Street analyst, said Lockheed is in fine shape to consider new options. "Major pressure on Lockheed's aircraft business, with reductions in F-22 and others, will trigger a strategic response; and unlike where they were five years ago, they have a solid balance sheet and good cash flows which gives them strategic flexibility," he said.

Long-Term Decisions

One Lockheed investor said he sees relatively smooth financial performance for the companies until 2006, when 2005 program cancellations and budget cuts begin making a financial impact. "I agree that a lot of people may head out of the sector, but I think that these companies, at least for the next two years, are going to do OK, whether programs get cut or not," he said. "Now, there's no reason for these stocks to go up over the next three months, which is why I shorted them. If everyone else runs away and the prices come down, I'll get back in." Despite the rough ride, he sees solid companies that will tough out the impending storm. Even major program cut impact "earnings per share by pennies," the investor said. "You have to be careful because this stuff adds up, but this sector is different today than 10 years ago. They're more diversified, their balance sheets are in good shape, managements are focused on shareholder return, but not blindly. They're buying back stock, and cash flows are great. These are not super-expensive stocks. Take Lockheed. They generated $2 billion in free cash in '04, plus the dividend yields are good. It's like an 8 percent bond. That's not bad."

Laura Colarusso contributed to this report.
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