Defense stocks clouded by U.S. budget anxiety

ATLANTA (Reuters) - U.S. defense contractors are anxiously awaiting U.S. President Barack Obama's fiscal 2010 budget, but some analysts think reforms and possible spending cuts on arms programs could pressure shares of those companies in the next year or two.

"The spending for this fiscal year and fiscal 2010 still looks healthy" despite slower growth rates, said Craig Fraser, managing director at Fitch Ratings.

"The biggest risk is what happens beyond fiscal year 2010," when there could be meaningful spending changes with Obama's imprint.

Over the past month, some analysts have cut price targets on defense companies, fearing that uncertainty about spending priorities under Obama could limit performance.

Heidi Wood, Morgan Stanley managing director, said last week the sector is underperforming partly because investors are unnerved by the administration's talk about "tough choices" and the need to reform defense procurement.

She said the sector historically does well in an election year, but its performance was not as strong the year after.

The Standard & Poor's Aerospace and Defense Index is off 13 percent this year.

Among big contractors, the stock of Lockheed Martin Corp has fallen nearly 18 percent so far in 2009, Boeing Co is off about 13 percent and Raytheon Co is down 21 percent.

Wood said defense stocks were a good investment heading into a recession, outperforming by a "measurable percentage," but generally did not bounce back as well as the overall market when the economy was heading back upward.

"It does look like we might potentially be at the risk of being left behind," Wood told a missile defense conference in Washington.

She added that the 13 or 14 years of rising defense spending appeared to be ending, given Obama's ambitious domestic agenda and his pledge to reform defense acquisitions.

Moreover, an expected shift of defense spending into "irregular warfare" and away from more traditional weapons programs, joined with the defense procurement effort could spell cuts for some major programs, she added.

"Unfavorable defense spending priorities, program cancellations and defense contract reform efforts will all be risks to investors over the next 12 to 24 months," Wachovia Capital Markets analyst Sam Pearlstein said in a research note this week.

Still, the sector is not likely to suffer as much as others that have less visibility on their sales or have been roiled by bankruptcies in the recession.

While pension costs may cut into profits of some of the biggest defense players this year, contractors may be spared the same fate that has battered retailers and other industries that rely heavily on consumer spending.

"This is one of the few industries that we're seeing these days where dividends are being increased," Fitch Ratings' Fraser said, nothing recent payout boosts at Raytheon and General Dynamics.

"If there were a surprise to come out of the administration and there were dramatic changes to programs and procurement, the industry has the financial strength to withstand," he said.

(Reporting by Karen Jacobs, with additional reporting by Andrea Shalal-Esa in Washington; Editing by Bernard Orr)