Boeing Deploys Shields to Combat Shrinking Defense Spending

By FOXBusiness

As the wars in Iraq and Afghanistan wind down and the U.S. attempts to shrink its ballooning budget deficit, the American defense industry is bracing for leaner times in the years ahead.

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The specter of even harsher conditions has been raised by looming $50 billion-a-year in mandated cuts in the wake of the Supercommitte’s failure last year to find $1.2 trillion in savings.

Yet aerospace and defense giant Boeing (NYSE:BA) appears to be better insulated against the likely carnage in today’s thriftier defense world. That’s because the iconic American company has the luxury of falling back on rising demand for its shiny, more fuel-efficient commercial jets and an influx of crucial exports to far-flung places like Saudi Arabia.

“They’ve been proactive and pretty successful so far,” said Richard Aboulafia, an aerospace analyst at consulting firm Teal Group. “They’ve had to live in this environment for some time now. They’re getting quite good at it.”

How Much Will Spending Shrink?

Like most defense companies, the outlook for Chicago-based Boeing has been clouded by an unclear budgetary picture. But Boeing isn’t wasting any time -- last week it disclosed plans to close an 83-year-old plant in Wichita, Kan. due to shrinking spending.

“The bottom line is sooner or later the defense budget is going to be cut below the current” levels, said Todd Harrison, senior fellow for defense budget studies at the Center for Strategic and Budgetary Assessments. “The timing over the next year and magnitude of the cuts is very uncertain.”

There appear to be at least three baseline scenarios for U.S. defense spending in the near-term.

Ironically, the best-case outcome is the one spelled out by the White House last week calling for an initial cut of $487 billion to the defense budget over ten years, beginning in fiscal 2013, by downsizing the Army and Marines

If this is the extent of the cuts, there’s “no reason” Boeing would “need to make terribly Draconian cuts,” said Aboulafia.

Unfortunately for defense contractors, this seems to be the least likely scenario.

Doomsday Scenario?

At the opposite end of the spectrum, looms sequestration, a term that refers to the mandated cuts of $492 billion over the next 10 years that were triggered by the Supercommittee debacle.

If Congress fails to stop this ticking time bomb, “you’ve got a potentially disastrous circumstance on your hands,” said Aboulafia.

That’s because the Pentagon wouldn’t be able to meet these mandates by simply cutting back on personnel, benefits or even through base closures, which take considerable time. Instead, costly contracts with defense contractors would be on the chopping block.

“The cuts under sequestration would likely to be focused on acquisition programs because you can stop buying things quickly, even if it ends up costing you more in the long run,” said Harrison. “Virtually every acquisition program would be impacted.”

Boeing has plenty of government contracts, including 2011 deals worth $4.9 billion to build the KC-46 tanker for the Air Force and $1.7 billion to manufacture the P-8 Poseidon for the Navy.

Congress Likely to Cave

“Everyone knew the good times had to end and that Iraq and Afghanistan were eventually going to terminate and that would eventually lead to a downturn. They weren’t prepared for sequestration,” said Aboulafia. “That has got people really spooked.”

However, industry insiders believe the incredibly-disruptive and painful nature of sequestration will ultimately help force Congress to at least delay these painful defense cuts.

Harrison said he sees a “fair chance” a lame-duck session of Congress returns after the November elections to either reach a compromise or delay the point of enforcement.

“I don’t think people take sequestration all that seriously,” said Aboulafia.

That means defense spending cuts will likely be harsher than the Obama Administration’s proposals, but not near the doomsday scenario some are fearing.

Of course, credit-ratings firms may punish Congress for caving by downgrading the U.S. debt rating, which could increase borrowing costs.

Even in a worst-case scenario for defense, Boeing appears to be better positioned than peers like Lockheed Martin (NYSE:LMT), Northrop Grumman (NYSE:NOC) and Raytheon (NYSE:RTN).

Exports to Offset Shrinking U.S. Orders

That’s partially due to Boeing’s recent success on the export side.

In a mega deal touted by the White House, the U.S. agreed late last month to sell $29.4 billion of Boeing F-15 fighter jets to the Kingdom of Saudi Arabia. It also has a slew of commitments for its C-17 transport aircraft from India and the United Arab Emirates

“They had a long string of negatives,” said Aboulafia, pointing to setbacks when Europe, Brazil and Japan signed contracts with rival defense companies. “After a couple of years of persistence, they got the big Saudi arms contract, which made it all good.”

While he believes Boeing is overall in “good shape,” Mark Bobbi, a senior analyst on military aircraft at IHS Jane’s Information Services, said the company is lagging behind rivals in terms of weaponry, including tactical missiles and precision-guided weapons.

To make up the ground, Bobbi predicted Boeing could acquire a segment of Lockheed or Raytheon or even target a takeover of a company such as Alliant Techsystems (NYSE:ATK), which has a market cap of $2 billion.

Boeing is further insulated from the defense spending slowdown by its balance between commercial and defense, giving it a diversification that few peers other than Gulfstream parent General Dynamics (NYSE:GD) have.

In 2010, Boeing generated commercial-airplane revenue of $31.8 billion, virtually equal to its $31.9 in defense, space and security revenue.

Oil Prices Boost Commercial Demand

Despite the sluggish global economy and struggles in the U.S. airline sector (American Airlines parent AMR Corp. filed for bankruptcy in November), the commercial aerospace industry is booming as carriers fret about energy costs and air travel rises in emerging markets.

Due to “$100-plus world oil prices for as long as the eye can see,  they are being forced to recapitalize fleets with more fuel-efficient planes,” said Bobbi.

Bobbi pointed to record delivery of Boeing’s 777, 787 Dreamliner and forecasts for more than 1,000 orders for the 737 MAX.

“The commercial aerospace sector is entering what could be a prolonged period of increasing deliveries,” analysts at Standard & Poor’s wrote in a new report this week that highlighted the divergence with defense. "Aerospace companies are reporting large order backlogs and should benefit from new models despite the headwinds of a weak global economy.”

Last month Boeing inked a $19 billion deal with Southwest Airlines (NYSE:LUV) for 150 new 737 MAX aircraft and received commitments from Singapore’s Lion Air to buy $21.7 billion of planes -- the largest commercial order in company history.

In 2011, Boeing delivered 477 commercial aircraft, up 3% from the year before.

“Everyone else is talking about diversification,” Aboulafia said, “but this is a company that is diversified out of the box.”