The full implementation of sequestration's defense spending reductions
will increase pressure on revenues, but Fitch believes it will not
necessarily have a significant effect on credit ratings in the U.S.
aerospace and defense sector if companies take actions to offset the
sequester's impact. The benefits of cost reductions, international
contracts, and cash deployment flexibility should not be ignored in
evaluating the U.S. defense sector's credit profile, and we believe most
manufacturers have the opportunity to adapt to the challenging revenue
environment to preserve current ratings. Additionally, many defense
companies boast strong liquidity positions and benefit from product and
geographic diversification, somewhat mitigating the impact from expected
Department of Defense (DOD) revenue declines.
A challenge defense contractors will face is determining how to adapt given the uncertain execution of the sequester, the pending expiration of the Continuing Resolution in late March, and the overall fiscal pressures in the federal government. Because of the lag between budget authority and outlays, we expect the bulk of sequestration's impact could be shifted into fiscal 2014, providing some additional time for companies to adapt. However, non-investment-grade companies and companies with weak diversification are most at risk in the current environment, and program-specific reduction details will be needed to evaluate the full impact on defense credit profiles.
Over the past several years, much of the U.S. defense sector has been planning for lower revenues, with restructuring actions taken throughout the industry. Stagnant revenue growth has been a theme for many defense contractors, yet some were able increase operating margins in 2012 despite modestly lower revenues. Most defense contractors have flexible cost structures with relatively low fixed capital. International revenue growth is another way defense contractors can offset the impact of weaker U.S. defense spending, and there were a substantial number of large international opportunities in the past year.
Unless sequestration is replaced or modified, DOD spending will likely be reduced by approximately $1 trillion over the next 10 years compared with previously anticipated spending levels. The reductions come from the combined impact of sequestration and the Budget Control Act of 2011. Budget cuts to modernization spending (procurement plus research and development [R&D]), the most relevant part of the budget for defense contractors, are likely to account for a disproportionate percentage of the reductions.
Most of the spending cuts are from projected budget growth and come off the existing high spending levels. We expect inflation adjusted spending will likely decline, albeit modestly, over 10 years. As an example, we estimate the implemented budget cuts would only reduce base budgets back to the levels seen in fiscal years 2007 or 2008.
A key risk in the sector could be cash deployment to offset the impact on earnings from lower revenues. However, this has not been a serious issue so far, and some companies (including L-3 Communications and Alliant Techsystems) have allocated cash to debt reduction.
The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article, which may include hyperlinks to companies and current ratings, can be accessed at www.fitchratings.com. All opinions expressed are those of Fitch Ratings.
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