Defense Contractors Fall Under Budget Guillotine

If the U.S. government was a teenager with a credit card, it'd likely have been grounded decades ago for its poor spending habits. Unfortunately for us and the defense sector, it's just not that easy.

In August, with the debt-ceiling window rapidly approaching, Republicans and Democrats "agreed" (if I can call it that) to raise the debt limit in exchange for what would amount to as much as $2.2 trillion in federal budget cuts over the next decade. By November 2011, a joint committee of Congress was to have voted on how to reduce the federal budget by up to $1.5 trillion or risk a sweeping $1.2 trillion reduction in spending across the board. To no one's surprise, they failed!

In the back of most American's minds, we sort of knew these cuts would never materialize, but this came as particularly poor news to the defense and health care sectors, which knew they would face steep funding cuts if Congress couldn't come to an agreement. Last night we began to see the first effects of those cuts with telecommunications equipment provider Harris (NYS: HRS) and government services provider L-3 Communications (NYS: LLL) reporting their earnings results.

Don't let Harris' gains yesterday fool you -- things are just "less bad" than what investors had predicted from the start. For the second quarter, Harris' sales and profits were relatively flat with profits beating expectations by $0.03 and sales falling short of Wall Street's estimates. Likewise, its full-year 2012 forecast was in line from a profit perspective, but its $6 billion in revenue guidance fell shy of the $6.15 billion to $6.3 billion that it had previously guided toward.

Harris placed much of the blame squarely on decreased government spending. It now anticipates its RF communications segment sales will decline by 6%-8% in 2012, with tactical communications leading the way with a 12% decline in revenue.

L-3 Communications reported similar results with a $0.12 top-line earnings beat, but came in with fourth-quarter sales well below the Street's expectations ($4.02 billion vs. $4.18 billion). With sales falling almost 6% from the prior-year quarter, L-3 CEO Michael Strianese explained the dilemma in a nutshell: "Sales performance reflected our areas of competitive strength as well as a challenging defense budget environment which is creating headwinds in the AM&M, government services and electronic systems segments." Despite holding to previous forecasts, I'm not feeling optimistic about these results -- and neither should the rest of the defense sector.

It isn't just budget cuts that are hurting near-term order forecasts. Troops pulling out of Iraq and a cutback in the troop count in Afghanistan later this year are constraining defense contractor budgets.

Although I often tend to disagree with analysts, Morgan Keegan analyst Brian Ruttenbur is well within reason to be cautious about defense contractor earnings in the fourth quarter. Last week he commented that he expected roughly 5% revenue declines from Northrup Grumman (NYS: NOC) , Lockheed Martin (NYS: LMT) and Raytheon (NYS: RTN) when they report their fourth-quarter results. Lockheed and Raytheon actually reported their results shortly after Mr. Ruttenbur's note -- and sure enough, Lockheed's sales fell by 4.3% over the year-ago period, while Raytheon's dropped by 6%.

Defense contractors are turning to share repurchases and fortifying dividends in order to keep shareholders happy, but I'm not convinced that it will be enough to buoy their stock prices. In my opinion, fiscal 2012 through 2014 could be a very rough time for the defense sector and there simply aren't enough catalysts present to make me want to own anything in this sector.

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At the time thisarticle was published Fool contributor Sean Williams has no material interest in any companies mentioned in this article. He can be quite defensive at times. You can follow him on CAPS under the screen name TMFUltraLong, track every pick he makes under the screen name TrackUltraLong, and check him out on Twitter, where he goes by the handle @TMFUltraLong. The Motley Fool owns shares of L-3 Communications, Lockheed Martin, Raytheon, and Northrup Grumman. Motley Fool newsletter services have recommended buying shares of L-3 Communications. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy that's never offensive to its readers.

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