OCO Shrinkage

Overseas contingency operations funding may shrink faster than some folks think, according to a new research note from Credit Suisse analysts issued today. Here's the summary:

NATO Leadership Affirms Withdrawal of Almost All Allied Troops by End of 2014; Result Is Likely End to Most OCO Funding with War's Conclusion in Late-CY14: Yesterday, NATO Leadership issued a joint declaration confirming ISAF/NATO transition to Afghan forces of all combat missions by mid-2013 and withdrawal of NATO troops by end of 2014. The declaration in essence supports President Obama's plan of completing the drawdown by the end of CY14. While Obama's commitment to ending the war has been largely anticipated at this stage by investors, these actions suggest a strong possibility that OCO funding will aggressively contract from the $89B FY13 request to well below the OMB/DOD plan for sustained $44.2B in OCO per year between FY14 and FY22. The comments imply no OCO funding beyond Q1 of FY’15.

More of a Surprise for Contractors than Investors: While this may be obvious to most investors, it appears many contractors have been relying on continued OCO as per the existing budget materials. We have been expecting a sharp decline in OCO funding, but believe most contractors have been relying on the $44.2b annual wedge being used by both OMB and the DoD Comptroller. The $89B in the FY13 OCO request pays for 70k U.S. troops at a cost of $1.3M each. The FY14 placeholder of $44.2B projects a 50.3% drawdown in FY14. This would fund 34k troops at $1.3M each. We assume a more realistic FY14 OCO is $39B-$46B for 30-35k troops. Also, we assume FY15 OCO of $10-11B for the final period of Oct to Dec 2014, plus ~$2.7B for U.S funding of the Afghan National Security Forces (Army Police), translating to a total FY15 OCO of $11-15B. Army & Marines will also likely request temporary RESET funding, with Army focus on 2015-2016 and USMC on 2014-2015. Recent congressional hearings suggest Army is identifying worst-case ceiling of ~$20-23B in RESET total costs, while USMC is projecting ~$3.2B in RESET costs after combat ends.

Primary Impact to O&M; Secondary to Procurement: O&M and procurement account for 72% & 11% of OCO funding respectively. The biggest impact would be to Army, which consumes $50B (56% of FY13 OCO request), with Navy & Air Force likely to suffer less impact because each consumes ~16%. A faster ramp-down in OCO clearly impacts infrastructure, logistics and operations suppliers including KBR, Fluor, Bechtel and DynCorp, which have been feeding from the LogCap contract (Army logistics), but which have also already seen significant downward revenue and EBIT assumptions. It will also impact gov’t services providers such as MANT & CACI as brigades return from Afghanistan and the deployment cycle ends. Contracts such as Army S3 will slow materially.

RESET Directed to Rotary Likely to Be More Robust: This will be predominately directed at rotary wing aviation (Boeing/Sikorsky/Textron) and most radios. This RESET funding will likely be of short duration (2-3 years).