NEW YORK (TheStreet) -- The U.S. Department of Defense's trimming of its base budget to $525 billion from $531 billion might seem like troubling news for defense companies, but much of the cuts were already telegraphed to the market and some companies will benefit from these budget changes.
The DoD is charged with saving $487 billion over the next 10 years, with $259 billion, or 53%, over the first five years. The fact that the budget has more cuts in the front half than the back was a surprise to some, according to Lazard Capital Markets analyst Michael Lewis, adding, however, the budget was in line with what he expected.
The military focus will now be on areas such as intelligence surveillance reconnaissance and data collection, according to the Defense Department. A larger spending focus also will be placed on the Asia-Pacific and Middle East regions.
One program being cut is Northrop Grumman's (NOC) Global Hawk Block 30, an unmanned aerial system.Northrop Grumman got $763 million in last year's Defense Authorization Bill for the Global Hawk Block 30, said Drexel Hamilton analyst Rick Whittington. Northrop, in a statement, said it was "disappointed with the Pentagon's decision, and plans to work with the Pentagon to assess alternatives to program termination." On the positive side, Northrop Grumman will see at least some incremental gains in the intelligence surveillance reconnaissance area though, Lewis noted in a report. He said he anticipates that AeroVironment (AVAV) will benefit the most because of its unmanned systems, as the company is the only pure-play company focusing on unmanned systems, but some of the other major defense companies, including Lockheed Martin (LMT), Northrop Grumman, L-3 Communications (LLL) and Boeing (BA) will see gains in this area as well. Lewis has a neutral rating on AeroVironment. The stock has decreased 9.63% year to date. Another space that will see gains is in electronic warfare and communications. In this area, Lewis said he favors Mercury Computer Systems (MRCY), which is a pure play in the ISR and EW space. He has a buy rating on Mercury Computer with a $19 price target. The stock has risen less than 1% year to date. For updating radar on tactical ships and aircraft, Lewis said in a report that Raytheon (RTN) stands to benefit with its surface combatant system AEGIS and its AESA radars. Lewis doesn't cover Raytheon. Both Lewis and Whittington noted the precise magnitude of the budget changes and whether they lean more toward the positive or negative side for each company can't be determined yet until further information is released in two weeks. In addition to removing programs, the budget also calls for a decrease in troops. The Army will lose 72,000 troops in the next five years; the Marines will have 20,000 cut. "By reducing the headcount of the Army and Marine Corps while cutting the Air Force's squadron/wing count, i.e. fewer airplanes, as well as retiring Navy ships, you further reduce future expenditures to modernize/update the present (larger) armed forces, as well as future operating expense (fuel, food, clothing, supplies, armaments, training, etc)," Whittington wrote in an email. While news of these budget cuts will likely "make people more timid about entering the sector," Lewis said, he noted that the "overall net impact is relatively minor." The only other risk Lewis sees on the horizon is that of sequestration, which would cause large cuts across the board. He added that it's too soon to tell if that will happen. -- Written by Alexandra Zendrian
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