Pentagon pitches austerity plan to nervous Wall Street

Tue, Oct 5 2010 By Andrea Shalal-Esa WASHINGTON (Reuters) - Deputy Defense Secretary William Lynn met with over a dozen Wall Street analysts last week to map out Pentagon cost-cutting plans aimed at averting a collapse in defense spending the likes of which was seen at the end of the Cold War. Lynn tried to assure the analysts that the Defense Department could continue to fund its biggest weapons purchases and still meet personnel costs by trimming $100 billion over five years from overhead and low priority programs, according to accounts of the meeting obtained by Reuters. The Pentagon confirmed the meeting took place, but gave no details. Investors remain worried and industry executives are already scrambling to find other revenues to offset the expected contraction in military demand. "Nobody on Wall Street believes that defense spending will remain stable. The country is running a budget deficit of $1 billion every six hours, and defense will have to be part of the solution," said analyst Loren Thompson of the Virginia-based Lexington Institute. He said Pentagon officials were losing credibility because they were not facing up to that budget reality, and had not yet drafted policies to deal with the coming downturn and the wave of consolidations already hitting the sector. Analysts at the meeting were sworn to secrecy, but sources familiar with the proceedings said Lynn faced tough questions about future profit margins and the Pentagon's ability to maintain a choice of suppliers given decreased demand for weapons. Lynn, a former executive with Raytheon Co, responded, according to these accounts, that the Pentagon funds most research and development programs -- in contrast to the commercial sector -- pays its bill faster, and still offers companies profit margins around 12 percent. Joseph Nadol of JP Morgan cited current modest valuations and poor performance of defense shares in a note on Tuesday, saying the stocks "will have a difficult time outperforming the broader market in the coming years." The Standard & Poor's Aerospace and Defense Index has risen 6 percent this year but is off 25 percent from an all-time high reached in October 2007. While there could be some trading rallies, and prices could rise somewhat if the Pentagon's fiscal 2012 budget guidance was "mediocre but not disastrous," Nadol said his firm's estimates were generally declining. NOT MUCH UPSIDE Nadol and other analysts say the bad news is already factored into defense stocks, which should give them some resilience. But they don't see much upside either, given the overall economic outlook and growing concern about deficits. Friday's closed-door meeting in New York was the latest of a series of outreach meetings with industry, lawmakers and investors that have been hosted by Lynn, Defense Secretary Robert Gates, and chief weapons buyer, Ashton Carter. The meetings stand in stark contrast to the tenure of Gates' predecessor, Donald Rumsfeld, who refused to meet with industry executives on principle. Pentagon press secretary Geoff Morrell said the meetings were part of a larger outreach effort to change the culture of the Defense Department and not some new lobbying campaign to "woo or win over industry investors." "It is in our interest for there to be a healthy industrial base in this country," he said. "But we don't do investor relations here. That's not our responsibility." Defense consultant Jim McAleese said the frequency of the meetings, and the involvement of the most senior Pentagon officials showed that they "do realize that the threat to defense funding is both credible, imminent and quantifiable." Rob Stallard with RBC Capital Markets Corp said Gates' personal engagement had helped him cancel some programs long propped up by Congress, including the Lockheed Martin Corp F-22 fighter. "It's a sign that Gates means business." But Stallard said Congress would still likely defy a veto threat and continue funding the Pentagon's current target for cuts -- a second F-35 engine built by General Electric and Britain's Rolls Royce. Gates' plans to retire next year could also make it difficult to sustain the reforms and stave off bigger cuts to the budget in coming years, analysts say.