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Stocks Likely to Bleed If Congress Slashes Budget: John Dorfman

Listening to both Republicans and Democrats spout off these days, it sounds like austerity is the new patriotism. Both parties vow to cut federal spending. Republicans, urged on by their Tea Party wing, say deficit reduction is their top priority.

If and when rhetoric begets actions, stocks that depend on federal spending for a significant part of their revenue will be scrutinized by investors.

Tea party co-founder Mark Meckler said last month that all aspects of spending, even defense, “must be on the table.” Many analysts have lowered their earnings estimates for military contractors.

Health-care companies relying on revenue from Medicare are also under the sword of Damocles.

In these and other industries, investors need to weigh how much of the budget cutting news is already reflected in the price of a particular stock. The higher the share price relative to earnings, the more vulnerable it is. Some companies threatened by budget cuts are already so cheap their shares may be worth buying.

In my opinion, that’s the case with defense stocks. Raytheon Co. and Lockheed Martin Corp. sell for about nine times earnings, General Dynamics Corp. and Northrop Grumman Corp. for about 11 times earnings.

General Dynamics, for example, showed earnings growth of 10 percent or more in seven of the past eight years. Yet analysts foresee only 5 percent growth in 2011.

World of Trouble

I believe lawmakers will decrease defense spending, but given the conflicts simmering around the world, I expect mild reductions. Consider some developments in the Middle East in the past few months:

-- The people of Egypt rose up against Hosni Mubarak’s regime.

-- Iran continued developing nuclear weapons, and boasted that it has “complete domination” over the entrance to the Persian Gulf.

-- U.S. forces are struggling in Afghanistan, and the people of that country seem to have no faith in the central government.

-- Sectarian fights rage in Iraq, which wants the U.S. out but has no compelling plan for stability.

I haven’t even mentioned Pakistan or Israel yet. I think the point is obvious: The need for U.S. military force may be heightened in the next few years, even if it’s inconvenient from a budgetary standpoint.

Vulnerable Programs

If Congress can’t revamp the defense budget too much, it may have to cut health-care spending more than it otherwise would. That could mean lowering reimbursement rates for Medicare or Medicaid, or restricting permissible expenses, or both.

Health maintenance organizations that get a large slice of their revenue from Medicare seem vulnerable. That includes companies such as Molina Healthcare Inc., based in Long Beach, California, and Healthspring Inc., based in Franklin, Tennessee. At 27 times earnings, Molina seems more at risk than Healthspring at 10.

Long-term care facilities, also known as rehab hospitals, could find the federal government stingier than before. National Healthcare Corp., based in Murfreesboro, Tennessee, looks vulnerable. The company gets 70 percent of its revenue from the federal government, according to Barclays Capital. The stock isn’t cheap, at 17 times earnings.

Cheaper Looks Better

Also at some risk are health-care companies whose treatments are expensive, especially if there are some cheaper therapies available. Zimmer Holdings Inc., with headquarters in Warsaw, Indiana, dominates the orthopedic implants business, but may find doctors more reluctant to use top-of-the-line implants that carry high profit margins.

Similarly, Boston Scientific Corp., a medical device manufacturer, makes stents to keep blood vessels open, but cheaper stents or drug treatments might be substituted.

Home health-care agencies may also face reduced reimbursements or controls on the number of visits care workers are permitted. Amedisys Inc. of Baton Rouge, Louisiana, is the subject of three investigations seeking to determine whether it overcharged Medicare. A possible saving grace is that a lot of bad news is already priced into the stock. The company’s shares sell for eight times earnings.

Besides defense and health care, selected stocks in other industries may also be vulnerable. For-profit colleges, for example, depend on the federal government to guarantee the student loans that pay for their students to attend. Without loans, most students couldn’t go, and without federal guarantees few lenders would issue student loans.

College Daze

Particularly risky is Corinthian Colleges Inc. of Santa Ana, California, which gets 90 percent of its revenue from the federal government, according to Barclays Capital. In November, I explained some reasons why I would stay away from Corinthian Colleges shares, such as the fact that many of its students are struggling to pay back their loans.

Also dependent on federal money is Corrections Corp. of America, a builder and operator of for-profit prisons. The Nashville, Tennessee, company has a consistent history of profits, but growth slowed to single digits last year.

I hope that Congress does not choose to cut spending on cyber-security. If it does, though, Keyw Holding Corp. would be in some trouble. A leader in that field, the Hanover, Maryland, company sells for 25 times earnings.

Disclosure note: Personally and for clients, I own shares of General Dynamics and Amedisys. I own Raytheon for a couple of clients. I have no long or short positions in the other stocks mentioned in this column.

(John Dorfman, chairman of Thunderstorm Capital in Boston, is a columnist for Bloomberg News. The opinions expressed are his own. His firm or clients may own or trade securities discussed in this column.)

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