February 15, 2011 / 8:51 PM / 9 years ago

Analysis: Weaker budget outlook becoming reality for defense

ATLANTA (Reuters) - Major defense companies are in for tough sledding if slowing U.S. budget growth becomes reality, while companies that excel in niche technologies such as cybersecurity could be largely untouched and even emerge winners.

President Barack Obama’s $671 billion defense budget for fiscal 2012 is down 5 percent from the amount requested for the previous year. It calls for an increase in the Pentagon base budget to $553 billion for next year but includes $13 billion in program terminations.

While the budget was largely in line with expectations after the U.S. Defense Department unveiled plans last month to cut spending by $78 billion over the next few years, it provided more evidence that a weaker spending outlook was materializing for the sector, which benefited from steady increases following the September 11, 2001, attacks.

“The days of rapid growth of (weapons) acquisition spending are coming to an end,” said Todd Harrison, senior fellow with the Center for Strategic and Budgetary Assessments in Washington.

Defense contractors “are going to have to consolidate on the gains they’ve made over the last decade, try to lock in some of the key programs that are already in production, and there’ll be fierce competition for new start programs that do come along,” Harrison added.

Shares of major defense companies were mixed on Tuesday, with industry leader Lockheed Martin Corp (LMT.N) up 0.8 percent to $81.60, Northrop Grumman Corp (NOC.N) up 0.2 percent to $68.85 and Boeing Co (BA.N) down 0.9 percent at $71.61. General Dynamics (GD.N) was up 0.7 percent to $77.37 and Raytheon Co (RTN.N) was down 0.3 percent at $50.69. The Standard and Poor’s Aerospace & Defense index .GSPAERO was off 0.3 percent.


Program cancellations in the budget request are putting a further squeeze on contractors. The Expeditionary Fighting Vehicle marine craft program of General Dynamics was terminated, and funding for a U.S.-European missile defense system made by Lockheed in partnership with Italy and Germany will stop after fiscal 2013.

The defense budget request must be approved by Congress, and lawmakers in the past have rejected attempts to cut programs rich in jobs.

Morgan Keegan analyst Brian Ruttenbur cited “limited growth prospects” for larger defense contractors but said smaller companies that focus on niche areas such as cybersecurity could fare better.

He said in a note to clients that procurement and research and development — accounts in the budget that most directly affect industry revenue — were up nearly 2 percent on a combined basis from the fiscal 2010 level but down 0.4 percent from the amount requested for 2011.

The budget request included $2.3 billion for cybersecurity, which involves thwarting threats to computer networks.

Ruttenbur said potential gainers included FLIR Systems (FLIR.O), a maker of infrared cameras used in search and rescue and border patrol missions, and Force Protection (FRPT.O), which supplies ballistic-protected vehicles used in reconnaissance.

FBR Capital Markets analyst Patrick McCarthy said the focus on cybersecurity boded well for Lockheed and KEYW Holding KEYW.O.

Amid calls from the Pentagon in the last year to pare overhead and make weapons programs more affordable, major defense contractors have cut staff, put non-core divisions up for sale and looked to acquire companies that supply products that are in demand.

Last week, the Pentagon’s chief weapons buyer cited a desire to attract new suppliers and improve competition but added the department did not want to see mergers of the industry’s biggest companies.

Harrison said the Defense Department has long voiced a desire to do more business with new contractors to diversity its supply base.

But he added the weaker budget outlook could make it difficult for new players to see opportunity in the defense sector.

“In a flat and possibly declining budget environment, it becomes increasingly difficult to attract these firms, especially if you’re getting tight on profit margins,” Harrison said.

Additional reporting by Andrea Shalal-Esa in Washington; Editing by Steve Orlofsky

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