TEXT-S&P outlook for U.S. defense spending still negative

Wed Jan 2, 2013 11:14am EST

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Jan 2 - Standard & Poor's Ratings Services said its credit outlook for U.S.
defense contractors remains stable to negative after the U.S. Congress passed a
bill to delay sequestration by two months to early March. Sequestration, which
was supposed to have taken effect on Jan. 2, 2013, would have resulted in more
than $500 billion in additional across-the-board cuts to the U.S defense budget
over the next 10 years--$55 billion in fiscal 2013 (which began Oct. 1, 2012)
alone. The bill does include $6 billion in cuts for fiscal 2013, but details are
limited. Congress has yet to pass the fiscal 2013 budget, so the military is
being funded via a continuing resolution that expires in March 2013 and limits
spending to fiscal 2012 levels.

We believe that Congress will not implement the full amount of sequestration 
cuts, but it's possible an additional $100 billion to $200 billion of 
reductions will be part of any final agreement. We expect these cuts and the 
$487 billion of reductions already planned will result in flat to declining 
revenues and earnings for most U.S defense contractors for the next several 
years. However, defense contractors will likely only gradually feel the 
additional cuts over the next year as they are to "appropriations" (the amount 
the military is allowed to spend), not to "outlays" (what it actually spends 
in any period from funds already appropriated). In addition, funds already 
appropriated are often allowed to be spent over two to three years. The most 
immediate impact will likely be lower purchases of products and services 
funded through the operations and maintenance (O&M) portion of the budget. O&M 
funds tend to be more fungible than those for procurement and research and 
development, which are tied more directly to specific programs. O&M funds 
could also be used to fund the costs of the war in Afghanistan if a separate 
supplemental appropriation is not passed. 

We do not expect to take industrywide rating actions, even if Congress 
implements the full amount of sequestration cuts. We expect that large defense 
contractors, which generally have diverse weapons programs, will continue to 
generate good cash flow. The bigger risk to credit quality would be if firms 
respond to poor earnings growth prospects by materially increasing share 
repurchases, dividends, or debt-financed acquisitions.
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