Do Defense Spending Reductions Mean Private Equity Opportunity

January 14, 2013

The drop dead date for the debt ceiling debate is the day after Valentines, although some give it until March 1st.  Until this time, the President, or more likely Congress, has the obligation to adjust the cost side of the government’s balance sheet (spending).   Once there is some agreement on adjusting expenditure costs, Congress may likely agree to further weakening of the federal government’s balance sheet (i.e. increase the debt ceiling by allowing further cost increases).

The legal debt limit – $16.394 trillion – has already legally been hit.  The Treasury, though, has come up with some clever accounting adjustments, to buy some time for Obama and the Congress to work out some kind of an agreement.   The clever accounting adjustments include such things as reinvesting of federal workers’ retirement account contributions in short-term federal bonds.

With the clever accounting adjustments running out in about a month, the Treasury now has to decide which bills will be paid.  Among the checks to be sent out on February 15th are $1.1 billion in food stamps and unemployment insurance, $1.5 billion in defense vendor payments, $2.3 billion in health care costs (Medicare and Medicaid), $2.7 billion in military pay, $3.5 billion in federal personnel costs, $4.4 billion in other spending, $6.8 billion in income and corporate income tax refunds, and $30 billion in interest payments.

With this background in mind, which industries are most at risk from the debt ceiling debate and any potential compromises that come from an agreement?

Well, first and foremost, individuals and businesses connected with defense expenditures can probably expect a reduction of around 9 percent.  Who are these companies?  Here’s a list of the top 25, with a brief discussion of the top 5.

#1: Lockheed Martin

With about 70 percent of its revenue stemming from government contracts, any sequester deal probably puts Lockheed Martin’s political risk at about $3 billion.

#2: Boeing

With arms sales of about $32 billion, Boeing also has about $3 billion on the table with the sequester discussions.

#3: Northrup Grumann

With about $28 billion in business activity on the line, Northrup Grumann has about $2.5 billion at stake in the sequester discussions.

#4: General Dynamics

With about $24 billion in revenue on the line, General Dynamics probably has about $2 billion in political risk associated with the sequester discussions.

#5: Raytheon

Raytheon has about $23 billion in business that could be affected by any sequester deal, which puts their sequester risk profile at about $2 billion.

The rest of the top 25 includes L-3 Communications, United Technologies, SAIC, Oshkosh, Computer Science Corp, Honeywell, General Electric, Pratt & Whitney, ITT Exelis, KBR, URS, ATK, Rockwell Collins, Textron, Hewlett-Packard, ManTech, Navistar Defense, DynCorp International, Goodrich, and CACI International.

With this background in mind, and with the understanding that a crisis is a terrible thing to waste, what kind of opportunity for the private equity industry is there with the impending defense spending reduction?

The question, of course, requires a ton of continual research work on the part of professional analysts.  One thing has got to be surpsing to a good deal of private equity professionals, though – why hasn’t there been some big private equity deals in the defense industry announced over the past four or five years?

Perhaps the private equity industry has nothing to bring to the table when it comes to the big deals worth reporting.

Overall, the defense spending reductions will have a generally large effect on businesses connected with the defense industry.  How the defense spending reductions will affect connected businesses and whether private equity leaders find value out of the impending sequester deals is something worth watching.

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