Although the fiscal 2008 U.S. defense budget request recently submitted is more than 10 percent higher than the amount appropriated by Congress for fiscal 2007, excluding the costs of the wars in Iraq and Afghanistan, it was still well above the expectations of most industry observers, according to Standard & Poor's Ratings Services.
The demand environment for U.S. defense firms is expected to remain generally positive over the next one to three years and should support a generally favorable credit environment for U.S. defense contractors, the report noted. Although defense spending remains strong, the rate of growth will have to slow at some point, S&P added.
Changes or reductions to certain large programs is possible, but the largest prime contractors have diversified operations that limit the impact of significant reductions or cancellations. Smaller firms are more susceptible to program cuts, but many provide products that can be used on multiple platforms or have non-defense operations. In addition, limited program diversity is one factor reflected in the non-investment-grade ratings of almost all smaller defense contractors.
Along with the base Department of Defense budget of $481 billion, the President is requesting $142 billion for war costs in fiscal 2008 and $93 billion for the remainder of fiscal 2007.
While these numbers might seem large, the defense outlays are only 4 percent of GDP and 19 percent of the total federal budget, which is significantly below the levels of previous wars or the Reagan build-up in the 1980s.
Procurement and R&D, the parts of the defense budget that are most important to defense contractors, increase 13 percent to $177 billion in the fiscal 2008 budget request. Most large programs continue to be well funded in the near term.
Still, competing domestic spending priorities, war costs, the change in control of Congress and a change in administration in 2008 could be responsible for some programs being reduced, stretched out, or cancelled in future budgets, noted S&P.
The U.S. Army, which is bearing the brunt of combat operations in Iraq, received the largest increase of the military services at 20 percent. The budget requests include funding to increase the authorized strength of the Army by 65,000 troops and the Marines by 27,000 by fiscal 2012.
The increased troop levels could offer opportunities to companies that provide soldier equipment and ground vehicles, but higher personnel spending would probably put pressure on the procurement of aircraft, ships, and other large programs over the long term. Therefore, firms that have a large exposure to the Army are likely to benefit the most from current budget trends, according to the report.
"The change of control in Congress makes it less certain that the administration's requests will be approved as proposed," said Standard & Poor's credit analyst Christopher DeNicolo. "Although most members of Congress are reluctant to cut programs that provide high paying jobs in their districts, opposition to the war in Iraq and different priorities of the Democratic leadership could result in more significant changes than have been seen in recent years. However, the total amount spent is not likely to be reduced materially."
