Nine of the biggest names in the U.S. defense industry receive more than 70 percent of their revenue from the federal government and have the most to lose in the budget cuts approved by Congress this month, according to data compiled by Bloomberg.
For these defense contractors, it’s a replay of the 1990s, when the Cold War ended and the Pentagon slashed spending by a third. For government contractors in all industries, however, the stakes are significant.
“For some companies, the consequences are going to be large,” said Peter Morici, former chief economist at the International Trade Commission and a business professor at the University of Maryland. “They’re going to have to sell to the private sector, and that’s not going to be easy for them.”
When it raised the debt limit earlier this month, Congress cut $917 billion in spending over the next decade. A special congressional panel is expected to convene in September to try to identify another $1.5 trillion of cuts.
The hardest-hit group probably will be the defense industry, which received the biggest chunk of the $532 billion in federal contracts last fiscal year, a sum that exceeds the budgets of the five largest states combined.
Nine companies with a market capitalization of $1 billion or more receive at least 70 percent of their revenue from the U.S. government, according to data compiled by Bloomberg: ManTech International Corp., Booz Allen Hamilton Holding Corp., Northrop Grumman Corp., Raytheon Co., CACI International Inc., Lockheed Martin Corp., Oshkosh Corp., Harris Corp. and General Dynamics Corp. Three of those -- ManTech, Booz Allen and Northrop Grumman -- count on the federal government for more than 90 percent of their revenue.
ManTech fell 50 cents, or 1.4 percent, to $35.76 in Nasdaq composite trading, compared with a 1 percent decline in the Standard & Poor’s 500 Index. Booz Allen Hamilton dropped 0.8 percent, to $15.78, in New York Stock Exchange composite trading, while Northrop Grumman climbed 0.4 percent, or 19 cents, to $53.24.
A Smaller Pie
Companies will need lots of cash to withstand the new paradigm, said Russell Solomon, senior vice president of Moody’s Investors Service corporate finance group in New York.
“There’s a reorganization going on,” Solomon said. “There’s a smaller pie, and more companies than ever are going to be going after it.”
Government contracts more than doubled between 2001 and 2009, to $551.8 billion in 2009 from $220.6 billion in 2001, according to Bloomberg Government data. Last year, contracts ticked down by $19 billion to $532 billion.
Lockheed Martin, the world’s largest defense company, received $37 billion in U.S. government contracts for the year ending in October, the highest of any single business, according to data compiled by Bloomberg. General Dynamics and Boeing Co. are next, with $23.4 billion and $19.6 billion in contract awards.
While U.S. companies are looking to make up some lost federal revenue with new global sales, overseas companies also are exploring opportunities in the U.S. because their own markets are stagnating, Solomon said. That’s intensifying the competition for fewer federal dollars.
For companies like ManTech, it will be smaller growth after a decade of steady double-digit gains, said Brian Kinstlinger, an analyst with Sidoti & Co. in New York, who downgraded the company from buy to neutral on Aug. 4. There will be pressure to reduce prices on contracts that do survive, he said.
“It’s going to get harder for them,” Kinstlinger said. “It’s a bearish outlook for several years.”
ManTech has a $4 billion backlog in contracts and is pursuing more than $27 billion in new opportunities, Sally Sullivan, an executive vice president for the Fairfax, Virginia-based defense and intelligence information technology supplier, said in an interview. The company is emphasizing areas like Internet security and intelligence that are more likely to survive the budget-cutting process, she said.
How to Win
“We’re really focused on areas with priority budgets that aren’t going away,” Sullivan said. “We already feel like we’ve done the things we need to do to position well.”
Executives of McLean, Virginia-based Booz Allen said in an Aug. 9 conference call they’re seeking contracts with higher margins than they have had with defense, in areas like health care and financial services.
The companies that are succeeding are innovating, growing in segments that are expanding and exporting to countries where demand is greater, said Peter Cohan, a business professor and author of a book on Boeing.
Boeing has used government contracts to finance its research and development, Cohan said. The technology developed finds its way into commercial products, he said. It’s thriving also by selling to China, Cohan said.
“Many of these companies’ executives have memories of the cyclical nature of selling to the government,” said Cohan, who teaches at Babson College in Babson Park, Massachusetts.
Without diversification, “they know they’re going to be dead when the government starts cutting back,” Cohan said.
Defense contractors will face potential cuts of 10 percent or more, according to an Aug. 10 report by Moody’s Investors Service. Increased competition for a less robust market will pressure profits further, Moody’s said.
Companies are likely to continue to reduce payrolls and may be forced to restructure, Moody’s said. Big programs behind schedule or over budget are particularly vulnerable, including Lockheed Martin’s F-35 Joint Strike Fighter and the V-22 Osprey aircraft developed by Boeing and Textron Inc., it said.
“Boeing has been anticipating flattening defense budgets for some time,” company spokesman Daniel Beck said in an e-mail. “We have been positioning the company for growth by focusing on increasing international opportunities as well as moving into new markets.”
Morris Township, New Jersey-based Honeywell International Inc. expects sales from its defense and space unit to decline 2 percent to 4 percent compounded annually over the next three years, Michael Madsen, president of the unit, said in an Aug. 10 presentation. The declines will be made up in part by international revenue, he said.
“There is no question that we’re heading into a more challenging environment as we go forward,” Madsen told analysts at the conference, organized by Jefferies Group Inc.
Rockwell Collins Inc. makes parts for military programs “across the board,” company Chief Executive Officer Clay Jones said at the Aug. 10 conference. The Cedar Rapids, Iowa-based company will take a hit no matter what’s cut, he said. It gets about 45 percent of total sales from U.S. contracts, according to Bloomberg data.
“To say we’re in a position here where we’ll go unscathed is unrealistic, and I’m not going to say that,” Jones told investors. “But because of our ubiquity, I don’t see any one, or even two or three, major efforts that will rupture the hull of our boat.”
The Bloomberg Industries All Aircraft Parts Manufacturers Index, a market average of 44 defense supply companies, fell 1.2 percent. The index has declined 7 percent since Aug. 2, compared with a 4.9 percent decline in the S&P 500. Before then, the defense index had risen 7.7 percent since the beginning of the year.
While defense companies may be the most exposed to federal budget cutting now, drug makers, insurers and hospitals are keeping a close watch for cuts to Medicare in the next round of budget negotiations this fall. The pressure to restrain spending on entitlement programs may be substantial, as Medicare alone accounted for about 15 percent of the federal budget in 2009.
Doctors, hospitals and nursing homes already face reductions in reimbursements for next year. Health insurers saw some of the funding for Medicare Advantage managed care plans reduced by more than $200 billion in the 2010 health overhaul.
Pfizer Inc. Chief Executive Officer Ian Read said in an Aug. 10 interview he planned to fight attempts to reduce Medicare drug payments, given the more than $100 billion drug makers paid out to help finance the 2010 health-care law.
“We are only 10 percent of the health-care spend in the United States, and we are the most efficient part of that,” Read said.
UnitedHealth Group Inc. of Minnetonka, Minnesota, generates about 25 percent of its revenue from Medicare, said Ana Gupte, an analyst at Sanford C. Bernstein in New York, in an Aug. 2 note.
“In the worst case scenario of 2 percent across-the-board cuts to Medicare spending, we expect this to be a pass through for managed care,” Gupte said. “Margins will be preserved while revenues get hit by 2 percent.”
The reduction would be a one-time loss in 2013, when the automatic across-the-board cuts are slated to take effect -- not compounded over a decade as some investors fear, Gupte said.
UnitedHealth, Indianapolis-based WellPoint Inc. and Bloomfield, Connecticut-based Cigna Corp. declined to comment on the possible impact of the upcoming budget negotiations.
Federal information technology budgets will be flat, yet companies may still be able to take advantage of changing priorities, said Shawn P. McCarthy, an analyst with IDC Government Insights in Framingham, Massachusetts.
Agencies are shifting from locally installed and maintained computer systems to cloud computing. Microsoft Corp. and Google Inc. are potential beneficiaries, McCarthy said in a phone interview.
“You’re seeing a momentary blip in spending now in order to save money in the future,” McCarthy said.
Investors should avoid companies that specialize in government information technology, where spending has been weaker, International Strategy & Investment Group analyst Bill Whyman said in an August 9 report.
“There were a lot of clear signals that this was not just about spending money and being positive about technology,” Whyman said in a phone interview.