) -- Since the Senate voted to end production of the F-22 jet fighter, the stock price of defense company
has been badly beaten by its competitors. While the defense budget is on track to exceed half a trillion dollars in 2010, the axing of $1.7 billion in aircraft has investors in Lockheed spooked.
To make matters worse, the Pentagon said last week it's proposing delays and production cuts for the F-35 jet fighter, which Lockheed said would be a major contributor to revenue as each jet costs the military about $83 million. The U.S. was to have bought 513 F-35s over the next five years, but those estimates now appear too aggressive.
With the budget deficit growing ever larger and new agenda items such as health care threatening to rack up a tab of more than a trillion dollars in the next 10 years, something has to give. The question is, if defense spending, currently about 21% of the federal budget, is reduced, what will happen to the profitability of companies such as Lockheed,
Since the F-22 was dropped, Lockheed's shares have fallen 8.2%, while Raytheon, Northrop Grumman and Boeing have increase 13%, 23% and 43%, respectively. The
S&P 500 Index
has increased 19%.
Rivalry is high among defense contractors. With every new order comes a highly reliable source of income that has the potential to pay dividends for years. The F-22 led to billions of dollars in revenue for Lockheed Martin after the initial development as 187 of the $137.5 million jets were ultimately ordered.
Most of the major players have niches that give them an advantage over competitors. Raytheon, for example, is highly focused on missiles and radar systems, while General Dynamics is an expert on ground transportation, such as the Abrams tank, and submarines.
Overlap has been more than satisfied by the intense increase in spending because of the wars in Iraq and Afghanistan, and a push for defense spending, whether through Homeland Security or otherwise, by the Bush administration.
In addition to the publicly traded firms listed above, several private companies, such as
, also compete for a share of the defense budget. Should spending begin to soften, the high degree of rivalry may push out smaller firms that can't compete with the big names.
With a single buyer making up a massive portion of these companies' sales, success depends on consistent defense spending. While other countries are customers, the U.S. government outspends them all, effectively making America the only client of consequence.
Due to few switching costs and a plethora of similar products to choose from, defense contractors have little security on sales of a particular product. Luckily, defense contracts typically have many zeros in them.
The government's accountability is low, ensuring that when business is won, contractors are compensated for the variability in sales. Still, millions of dollars are sometimes spent to deliver a prototype that's ultimately rejected in favor of a competitor's product.
Suppliers include subcontractors such as
Pratt & Whitney
, a subsidiary of
, which produce key components for the main contractor. In the case of Pratt & Whitney, this includes the jet engines for the F-22 and F-35.
Suppliers' leverage is low because of the number of competitors vying for a piece of the defense pie.
also produce jet engines and other defense products.
Subcontractors' products can be replaced easily by other suppliers should a relationship sour. As a result of this interchangeability, prices from subcontractors are kept low, allowing for higher margins for the primary contractor, which helps the contractors eke out profitability even with the huge costs of development.
Producing a jet, nuclear submarine or tank isn't something that can be done by a start-up company out of a suburban office park. Until software programs are the weapon of choice, all viable entrants are already established.
Beyond the physical needs and expertise required to build advanced battle systems, a key component to winning business is connections to decision makers, which doesn't come cheap.
Politicians are dealing with a stagnant economy, an unpopular war and health care, all of which will probably reduce the perceived need to fund national defense. As a result, new competition would find it difficult to muscle their way into the industry. Likewise, lean times may lie ahead for existing contractors.
Traditional battle systems have been undergoing a sea change toward unmanned devices. In Afghanistan, most air missions are carried out by Predator and Reaper drone aircraft, which are safer and cost only a fraction of what traditional aircraft do.
As warfare has moved away from direct confrontation with an equally armed aggressor to a guerilla-type battle, drone vehicles make more sense. The Predator and Reaper are produced by General Atomics. Other major contractors will need to start incorporating this technology to stay competitive.
Massive arsenals that include huge tanks and aircraft may be a thing of the past, meaning defense contracts could shrink. Contractors that focus on counterinsurgency gear could be the big winners as troop armor and nimble ground transport become essential equipment.
Competitive forces in the defense industry are great, and the limp economy makes funding of vast military projects seem ridiculous. While there is still plenty of cash sloshing around in the industry to keep investors happy for now, it wouldn't be outlandish to suggest that the glory days of huge defense contracts may be over. As seen in the case of Lockheed, the loss of a key contract could send any of these stocks heading down.
--Reported by David MacDougall in Boston.
Prior to joining TheStreet.com Ratings, David MacDougall was an analyst at Cambridge Associates, an investment consulting firm, where he worked with private equity and venture capital funds. He graduated cum laude from Northeastern University with a bachelor's degree in finance and is a Level III CFA candidate.