How Will Sequestration Affect the Defense Industry: Lockheed Martin Corporation (LMT) and More

This article will focus on how sequestration could affect the defense sector. The failure of Congress and the Obama Administration to craft a “grand bargain” on tax cuts and the federal budget deficit in 2011 pushed lawmakers to pass a sequestration measure.

This is a fiscal policy mechanism where an amount of money equal to the difference between the spending limits set in a Budget Resolution and the amount actually appropriated to federal agencies is “sequestered,” or automatically cut, by the Treasury Department. Previously some observers have considered such a move to be implausible. And lawmakers have repeatedly kicked the can by cutting deals with the White House at the 11th hour.

Now, sequestration looms on the horizon again if a deal is not made by March 1, 2013. Given the current political climate – with the GOP circling the spending cut wagons, while the Democratic-controlled Senate has not proposed a budget in four years, sequestration is a possibility.

In short, the government will need to trim $85 billion in defense and non-defense spending in fiscal 2013 if sequestration takes effect. In particular, the Pentagon could be hit with an automatic 10% cut, which would force the Defense Department to pull back on spending with defense contractors. The ill effects have already hit the sector in the form of preemptive layoffs.

Defense contractors like Lockheed Martin Corporation (NYSE:LMT), Raytheon Company (NYSE:RTN) and Northrop Grumman Corporation (NYSE:NOC) expect a decline in profits in the first quarter of 2013.

Lockheed reported fourth quarter 2012 net sales of $12.1 billion compared to $12.2 billion in the same period in 2011.  Net earnings were $569 million, or $1.73 per diluted share, compared to $698 million, or $2.14 per diluted share, in Q4 of 2011. At the end of December 2013 the company was awarded a preliminary contract of $3.68 billion to build 31 F-35 fighter jets for the U.S. military. The deal was to be finalized early this year, but sequestration could scale the program back.

Meanwhile, Raytheon had a profitable year in 2012. The outfit makes the Patriot Missile System that was introduced in the 1991 Gulf War. Since then the company has gone on to provide this and other systems and services to a number of U.S. allies. For 2012, Raytheon reported net income of $543 million, or $1.57 a share, compared with $459 million, or $1.25 a share in 2011.

Both companies said sales would be “flat” this year because of cuts in military spending. But each outfit intends to cut costs by reductions in force and making programs more affordable while looking to international sales to make up for losses in the United States.