Standard & Poor’s Ratings Services said its credit outlook for U.S. defense contractors remains stable to negative after the U.S. Congress passed a bill to delay sequestration by two months to early March. Sequestration, which was supposed to have taken effect on Jan. 2, 2013, would have resulted in more than $500 billion in additional across-the-board cuts to the U.S defense budget over the next 10 years–$55 billion in fiscal 2013 (which began Oct. 1, 2012) alone. The bill does include $6 billion in cuts for fiscal 2013, but details are limited. Congress has yet to pass the fiscal 2013 budget, so the military is being funded via a continuing resolution that expires in March 2013 and limits spending to fiscal 2012 levels.
We believe that Congress will not implement the full amount of sequestration cuts, but it’s possible an additional $100 billion to $200 billion of reductions will be part of any final agreement. We expect these cuts and the $487 billion of reductions already planned will result in flat to declining revenues and earnings for most U.S defense contractors for the next several years. However, defense contractors will likely only gradually feel the additional cuts over the next year as they are to “appropriations” (the amount the military is allowed to spend), not to “outlays” (what it actually spends in any period from funds already appropriated). In addition, funds already appropriated are often allowed to be spent over two to three years. The most immediate impact will likely be lower purchases of products and services funded through the operations and maintenance (O&M) portion of the budget. O&M funds tend to be more fungible than those for procurement and research and development, which are tied more directly to specific programs. O&M funds could also be used to fund the costs of the war in Afghanistan if a separate supplemental appropriation is not passed.
We do not expect to take industrywide rating actions, even if Congress implements the full amount of sequestration cuts. We expect that large defense contractors, which generally have diverse weapons programs, will continue to generate good cash flow. The bigger risk to credit quality would be if firms respond to poor earnings growth prospects by materially increasing share repurchases, dividends, or debt-financed acquisitions.