CHICAGO--(BUSINESS WIRE)--Diminishing hopes for a bipartisan deficit reduction compromise in Washington are contributing to growing concerns over potential fallout from prospective automatic defense spending cuts. Should the special bipartisan 'super committee' fail in its effort to agree on $1.2 trillion in U.S. deficit reduction over 10 years, Fitch Ratings thinks U.S. defense contractors could face increasing pressure on their credit profiles.
The bipartisan committee is beginning work to meet the long-term deficit reduction goal specified in the August Budget Control Act that raised the federal debt ceiling. The bill outlined a procedure under which a failure to approve a bipartisan compromise by Nov. 23 could trigger $1.2 trillion in automatic spending cuts, with as much as $600 billion coming from national security budgets, starting in fiscal 2013.
U.S. defense firms have already been adjusting to a more uncertain Department of Defense (DOD) budget outlook as a result of planned reductions in Pentagon spending growth of $350 billion to $450 billion over the next decade. In such a budget scenario, revenue pressure linked to slower DOD spending growth could likely be managed through cost control, with little or no impact on defense firm ratings.
However, further cuts of as much as $600 billion in national security outlays over that same period could reduce revenue growth rates significantly for these companies, which derive the bulk of their revenue and cash flow from Pentagon contracts.
The ultimate impact of any automatic defense cuts would depend greatly on the timing of any projected savings and the focus of any cutbacks in such areas as DOD procurement and R&D. Deep cuts targeted more heavily toward the out years, late in the decade, would likely give contractors sufficient time to streamline cost structures to limit margin erosion in a flat or even modestly negative revenue growth scenario.
Still, should serious DOD spending retrenchment occur as early as FY 2013, defense firms would find it more difficult to avoid leverage increases as debt levels and cash pension funding could not be reduced quickly enough to keep pace with weakening DOD-related revenues and earnings. Firms may also come under pressure from shareholders to boost equity returns in a prolonged low earnings growth environment.
U.S. contractors, including Lockheed Martin and Raytheon, face significant pension funding commitments that may become more difficult to meet out of cash flow should Pentagon spending decline materially over time. This situation is only partly mitigated by the classification of pension costs as allowable costs under government cost accounting standards.
Over the near term, Fitch believes that U.S. defense credit profiles have some cushion to withstand lower revenues given contractors' healthy liquidity positions and healthy credit metrics for the existing ratings.
Similar budget issues are facing contractors in other regions, notably in Europe, as governments look for ways to reduce defense outlays in the face of ongoing market pressure to reduce fiscal deficits.
Additional information is available at www.fitchratings.com.
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