Defense in The Crosshairs

US defense spending continues to be a target of government budget cuts on Capitol Hill. While this clearly impacts US defense companies, industry leaders may do better than expected.

Home of the brave and their weapons

The US spends more on defense than any other country. According to SIPRI, the US was responsible for roughly 40% of worldwide military expenditures in 2012. It’s no surprise then that the US is home to some of the most well-known defense companies like Lockheed Martin. The company is famous for creating iconic American fighter jets like the F-16 Falcon, F-22 Raptor, and F-35 Lightening.

Defense budget belt-tightening

According to the US Office of Management and Budget, total US defense spending fell from $879 billion in 2011 to $850 billion in 2012. Spending is estimated to be $823 billion in 2013, and further reductions are expected in the years ahead.

For a company like Lockheed Martin, this trend should be a red flag. After all, the US Department of Defense (DoD) is Lockheed’s largest customer and the company derives over 80% of its revenue from the US government. Sure enough, Lockheed has already lowered guidance for the year ahead, citing expected government budget cuts.

However, the outlook for Lockheed may not be as bad as it seems. Here are a couple of reasons why.

Lockheed in the trenches

First, consider what it takes to become the largest defense contractor for the US government. In addition to large amounts of capital and resources, it also requires decades of specialized knowledge, experience, and connections related to working with the government. Lockheed has literally dug itself in with US military and defense programs.

Even if the government wanted to, it would be difficult to switch vendors. For example, Morningstar points out that after decades of using Lockheed as the sole provider of fighter aircraft, switching to another provider would mean totally revamping a program designed around generations of Lockheed systems and technology.

In other words, switching costs are just too high, and that makes Lockheed an essential and virtually infallible partner of the US government.

Proactive and effective management

A second consideration is that Lockheed has shown it knows how to successfully manage its business in different defense spending environments. For example, in the third quarter, Lockheed delivered lower year over year revenue, which was widely expected. However, both margins and earnings were actually higher than the year before.

This was the result of Lockheed taking quick and decisive actions to reduce costs as sales slowed. This type of proactive management is part of why Lockheed has a strong track record of operating performance. Lockheed has grown revenue, income, and cash flow over the past ten years.

In Summary

Shrinking defense spending will obviously have an impact on Lockheed’s revenues. However, as long as the US maintains a military presence, a deep-seated incumbent like Lockheed will have a place at the government’s table and will receive ongoing (albeit fluctuating) orders from the defense budget.

Perhaps more important than the size of the government’s budget is whether or not Lockheed can successfully manage operations through the changing defense spending cycles. Based on Lockheed’s track record of strong performance, the answer seems to be yes.

Victor K. Lai, CFA

This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss. Victor Lai does not own any of the securities referenced in this posting. Clients of Bellwether Capital Management LLC may own shares of the securities referenced in this posting.