The political papers out of District of Columbia are building speculation about the potential for a small deal that could lower the sequestration hit modestly for fiscal 2014/15.
A small curbing of sequestration took place in fiscal 2013 through the passage of Assistive Technologies Research Award (ATRA) in January, which shaved $12 billion off the cut that was to be applied to the Department of Defense (DoD). A small deal would also provide encouragement into the January Continuing Resolution expiration for fiscal 2014.
The fiscal 2014 budget remains under a continuing resolution that is tied to the sequestered levels of fiscal 2013 ($497 billion top-line excluding Overseas Contingency Operations, or OCO), but that level is still about $19 billion above the sequester-required base budget funding level of $478 billion.
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Deutsche Bank analyst Myles Walton said that expectations appear to be building that the budget conference committee chaired by Congressman Ryan and Senator Murray will find a compromise that at least put the fiscal 2014 on equal footing with fiscal 2013.
Politco and the Hill have reported there is potential for the committee to find $80 billion in sequester offsets over two years, which could relieve the DoD of about $20 billion per year of otherwise planned cuts in fiscal 2014 and fiscal 2015.
Meanwhile, the consensus sales estimate for large defense contractors appear to be inclusive of no major relief from sequestration over the next couple of years.
Given the relatively small size of the proposed mini-deal, Walton sees negligible impact for 2014 sales and about 3 percent upside to calendar 2015 estimates.
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In addition, the contractors are not standing still in the face of budgetary pressure and continue to find ways to keep costs down well in advance of revenue declines, which has up till n! ow translated into margin expansion and growth in cash per share.
The leading defense contractors in the country include Lockheed Martin Corporation (NYSE:LMT), Raytheon Company (NYSE:RTN), Northrop Grumman Corporation (NYSE:NOC) and General Dynamics Corporation (NYSE:GD).
From bottoms-up revenue build-up by armed service, each of the contractors' consensus sales estimate seem about right for a scenario of no sequestration deal over the next 12-18 months. Walton said LMT is about $1 billion ahead of what the bottoms-up revenue by service would imply.
Moreover, contractors have not been standing still in the face of declines. The slow pace at which the revenue declines are coming (due to budgetary lag) has allowed contractors to get costs and headcount down well in front of the revenue declines.
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The cost take-out and program performance continue to drive margins higher across the industry. Although return on invested capital expansion has reversed, it's been modest thus far.
Upside opportunity in the group could come from: a better than expected sequester scenario, better pension dynamics, which will be driving EPS growth. The continued isolation of key weapons programs from cuts by the DoD should also support the group.
Walton thinks risks to the downside could materialize from material negative program decisions. The DoD has to cut $65 billion from weapons spending in fiscal 2015-17 to hit sequester targets. The analyst also sees downside when DoD could become less contractor friendly.
Moreover, investor complacency on earnings multiples and false belief of a return to top-line growth in the near-term could spoil the party.
In this scenario, L-3 Communications (NYSE:LLL) is preferable on strong cash flow and General Dynamics appear to be favorable due to the opportunity for better than feared capital deployment.
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