Small Defense Contractors Rebound as Budget Concerns Fade

In five months leading up to the automatic U.S. budget cuts that unnerved defense industry executives, Kratos Defense & Security Solutions Inc.’s stock price plunged 29 percent.

Since March 1, when the across-the-board reductions began kicking in, San Diego-based Kratos has surged 59 percent -- forecasts of economic catastrophe notwithstanding.

“At the end of 2012, there was talk of doom and gloom that defense companies are going to go off a cliff, so investors sold us off,” said Eric DeMarco, chief executive officer of the contractor. “But that hasn’t happened, so they’re returning.”

After the start of the cuts known as sequestration, labeled a “doomsday scenario” by former Defense Secretary Leon Panetta, investors are returning to many of the smaller government suppliers whose shares slumped during months of budget uncertainty.

A Bloomberg index providing a sample of 17 small and mid-sized contractors, including Kratos, API Technologies Corp., Anaren Inc. and CPI Aerostructures Inc., has gained 20 percent since March 1. It fell 14 percent in the five months before sequestration kicked in, partly reflecting concerns they would be more vulnerable to budget cuts.

The surge comes as top U.S. defense contractors such as Lockheed Martin Corp., Raytheon Co. and Northrop Grumman Corp. reported second-quarter profits last week that beat analysts’ estimates and raised profit outlooks for the full year.

‘Bounce Back’

“You’re seeing a little bit of bounce back” for small defense stocks, “because the sky is not falling and companies are not going out of business,” said Mark Jordan, a St. Louis-based analyst at Noble Financial Capital Markets. “They may be able to manage in some reasonable manner.”

The shares of API Technologies, which makes electronics components for defense and medical applications, have risen 16 percent since March 1 after falling 4 percent during the previous five months.

The Orlando, Florida-based company, which has a market capitalization of $167 million, hasn’t been “affected by any programs that were either eliminated or to be eliminated,” Bel Lazar, API’s chief executive officer, said in a July 11 conference call.

The Pentagon, though, is now “more careful in terms of what they’re procuring and how much they’re paying,” he said.

Executives at Anaren, a small contractor that makes technology for military radar systems, assumed the cuts would prevent sales from increasing more than roughly 5 percent.

Failed Negotiations

Instead, the East Syracuse, New York-based company projects a 10 percent boost in revenue from its defense and space businesses this year, President Larry Sala said.

“We definitely had expected it to be more severe on the impact on our business than it has been to date,” Sala said in a phone interview of the sequestration process.

The automatic budget reductions were agreed to by President Barack Obama and Congress after they failed to reach an agreement on a deficit-reduction strategy. The cuts will strip $1.2 trillion from national security and domestic programs over nine years unless a compromise is reached.

Anaren’s stock has jumped 19 percent since March 1, which Sala attributed mostly to a buyout offer from a private equity firm, which the company rejected in May.

The surging shares of defense contractors from Kratos to Lockheed Martin don’t mean the industry has escaped the effects of the budget cuts, which required the Pentagon to make $37 billion in reductions this year.

Contractor Survey

An anonymous survey of executives from 84 defense companies conducted by the Arlington, Virginia-based Aerospace Industries Association found that 88 percent of respondents reported being affected by budget cuts in the last two years.

The group’s survey, conducted from May 21 to June 5, showed 84 percent had reduced sales or profits, 62 percent had trimmed production and 60 percent had contracts postponed or canceled.

Some small defense suppliers say sequestration already has hurt their businesses.

JWF Defense Systems LLC, which provides metal for weapons and armor systems, had revenue decline 80 percent from two years ago, said John Polacek, chief operating officer of the closely held company based in Johnstown, Pennsylvania.

The Pentagon has been slow to place orders because of budget indecision, compounded by furloughs of civilian defense employees, Polacek said in a phone interview.

Seeking Diversification

With the prospect of budget cuts continuing for another year, “we haven’t seen the worst of it yet,” Polacek said. The company has diversified, supplying the oil and gas industry, as a way to remain stable, he said.

Leading contractors such as Lockheed Martin and Northrop Grumman, whose shares have outpaced the 18 percent gain for the Standard & Poor’s 500 Index this year, boosted net income by cutting jobs, divesting poorly performing units and using cash reserves to buy back shares. The Pentagon has shielded big weapons programs such as the F-35 jet, the military’s most expensive weapons system, from the mandatory cuts.

“We’ve seen less impact from sequestration, writ large, than we expected to through this part of the year,” Bruce Tanner, Lockheed’s chief financial officer, told analysts last week. “The Pentagon has done a fairly masterful job kind of deflecting” cuts to weapons programs.

The increase in stock prices doesn’t mean small-cap companies are out of danger, analyst Jordan said. After $37 billion of defense reductions during the year that ends Sept. 30, the Pentagon estimates it will have to cut $52 billion if sequestration continues into the next fiscal year.

Sequestration ‘Reality’

“The real question is what kind of 2014 are you going to be facing?” he said. “The environment is probably not going to change, and sequestration is still a reality.”

Kratos, which makes electronics components for ballistic missile defense programs, has weathered the budget cuts partly because its sales to the commercial security market have jumped about 20 percent, making it less dependent on government contracts, DeMarco said.

With $1 billion in annual revenue, Kratos is also better positioned as a maker of defense products than some government service contractors may be, he said.

Even as the military cuts, some programs benefiting Kratos are getting funding increases, such as the Navy’s EA-18G Growler electronic attack aircraft. The Navy’s plan to buy 21 of the planes next year, up from 12 this year, is one of the changes that are “very important to Kratos’ overall business, our 2013 business plan and our future prospects,” DeMarco said in a May 9 conference call with investors.

Small Businesses

Kratos, with about 4,300 workers, also provides electronics for the ground-based interceptors in the U.S. missile defense system. The Obama administration announced plans in March to add 14 interceptors to 30 already in place in Alaska and California.

Defense Secretary Chuck Hagel said last month in a letter to lawmakers that the $52 billion in 2014 cuts would lead to continued furloughs of civilian employees, reduced training, base closings and less spending on weapons. Small business may be the most likely to be affected, he said.

“The disruption would spill over to defense industry,” Hagel wrote in a July 10 letter to leaders of the Senate Armed Services Committee. “Defense industry jobs would be lost and, as prime contractors pull back work to protect their internal work forces, small businesses may experience disproportionately large job losses.”

Sala, the head of Anaren, isn’t ready to predict such gloom for his own company anytime soon.

“We’re still pretty optimistic about growth,” he said. “Right now, we’re planning on our business being even stronger next year than it is this year.”

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