Wall Street View

Defense Secretary Robert Gates' budget and efficiencies proposals revealed yesterday are a sign the secretary "wanted to dialogue with the new Congress as quickly as possible, which is highly unusual a month before the budget's due date," according to an analysis by Wall Street firm Credit Suisse, which adds: "This provides rare visibility and opportunity to buy defense names with lower near-term risk in our view." Further, Raytheon and General Dynamics "all received good news today relative to expectations, and are our favorite names for a defense rally."

As for what the Pentagon's fiscal year 2012 budget request will look like, the Jan. 6 analysis states:

With today's unprecedentedly early confirmation of key budget details, we think the mkt continues to buy defense stocks ahead of Feb's budget release b/c headline risk is largely neutralized and defense valuations look attractive in a lofty market with the S&P 500 nearing 1300. With today's unveiling of FY12 DoD baseline at $553B (in-line w/ most recent expectations) and anticipated cuts for Expeditionary Fighting Vehicle (GD) and a one-year development delay on F-35 (LMT), investors shld now be much less concerned about negative news flow, at least between now and the budget release in mid-February, and that they have been looking for an entry point simply because they want to rotate out of more expensive sectors that now appear full. See Ex. 2 and 3 inside for positives and negatives with contractor implications.

Budget Specifics: Secretary Gates reiterated his initial efficiency plan, which targets $101B in savings (mostly from overhead accounts) and redirects these funds within DoD (to the weapons accounts) over a five year period (GFY12-16). He also confirmed $78B in separate cuts (also over the five year period), which had been anticipated since mid-December. The first tranche of the $78B cut is $13B and is reflected in the trimming of the upcoming FY12 baseline budget request from the previously planned $566B to the $553B noted above. Secretary Gates further stated that FY13 and FY14 would see modest growth before the baseline turns flat in FY15 and FY16. We expect the specific figures for this long-term plan (FY13-16) to accompany the FY12 budget request in the FYDP, and we have established our own FYDP forecast inside in Ex. 1.

Remain Cautious Long-Term as Future Cuts Cannot be Ruled Out: All of that said, we believe the new Gates plan may only last as long as he stays in his post, which should be until sometime this year based on his previous statements. Because we believe deficit pressure will continue to mount, and that Gates’ replacement will likely be a traditional Democrat, we see further downside to the long-term plan discussed above, and that negative newsflow will return at some point later this year. Ultimately, we expect the baseline budget to decline, starting with next year’s FY13 request. This is why we see a limited window of upside opportunity now for most defense names.