LL:In my column Wednesday, the National Taxpayers Uunion broke their cost analysis of the State of the Union and they told me the President's cost cutting measures on defense will save $15.6 billion. Even though there will be cuts, demand will continue for defense products. What are the technologies and services of tomorrow that despite these cuts will continue to grow?
RPL: Even with the defense draw down, there will be more emphasis on technology—replacing people with surveillance and sensor networks for example. It is likely that contractors will replace USG/DoD personnel—i.e. Dept of State/Diplomatic Security Service is taking on the role of force protection for US interests and augmenting the Iraqi forces providing that protection. That will be done predominantly through contractors.
SG: We see continued demand for rapid response and reconnaissance capabilities such as UAVs, helicopters and robotics. Additionally while there will be deep cuts in future combat systems programs, we think there will be demand for legacy systems such as the Stryker and Bradley fighting vehicles, and modernization programs that can extend the life and utility of current equipment.
LL: Analysts say the tightness in the defense budget is already baked into the defense stocks. Do you think the headwind facing these stocks is as bad as the markets are projecting?
SG: We agree that the defense stocks have in large part “baked in” budget tightening/cutting, as the issue has been in the public domain for well over a year now.
However, the uncertainty of the timing, scope and details of budget reduction is what continues to impact these stocks. The bloom is clearly off the rose for the public defense stocks as we’ve come out of the accelerated spending cycle of the 2000’s. However, uncertainty is always a market killer because it hurts the ability of portfolio managers to quantify risk. This is a variable that continues to impact defense stocks.
LL: With the budget cuts, there will be more jockeying for the government contracts. How much pricing pressure do you anticipate this will have on margins? Will they go higher? Or have they troughed?
RPL: No question this has an impact on pricing—there has been downward pressure on labor rates for government contractors and this will increase given the prospective pay freeze in USG. Furthermore—there is more teaming going on because the government is taking a very aggressive approach to putting out multiple award IDIQ (Indefinite delivery/indefinite quantity) contracts and further forcing competition for the work as the task orders come out.
SG: We believe that the DoD will move towards greater implementation of fixed price contracts to reduce risk. This will negatively impact margins.
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A Senior Talent Producer at CNBC, and author of "Thriving in the New Economy:Lessons from Today's Top Business Minds."