Fitch: Rising Pressure on U.S. Defense Credit Profiles

New York - 22 November 2011

The end of the 'Supercommittee' negotiations without an agreement increases the probability of Fitch's harshest Department of Defense (DoD) spending scenario (i.e. 'sequestration'), but Fitch expects less severe and/or more orderly spending scenarios are equally likely because Congress could act to avoid sequestration's automatic cuts beginning in January 2013.

Ratings Cushion For Now: Although pressure is rising on defense credit profiles, Fitch is not taking ratings actions now because most defense ratings have some cushion to withstand lower revenues given contractors' solid liquidity positions and healthy credit metrics for the existing ratings. Defense firms should also have time to adjust to the uncertain Department of Defense (DoD) budget outlook, and some companies have already been adjusting through restructuring actions and portfolio shaping.

Credit Risks: Non-investment grade companies and companies with weak diversification are most at risk in this environment, particularly the sequestration scenario. Fitch believes most large companies have the ability to take action to preserve investment grade ratings if they come under pressure.

'Cuts' Alone Appear Manageable: Sequestration aside, most DoD spending scenarios by themselves would not pressure the defense sector's overall credit profile if the cuts are not weighted toward the first few years. Most of the 'cuts' are from projected budget growth and come off of existing high spending levels. Inflation-adjusted spending will decline, but modestly over ten years. The industry should have time to adjust cost structures.

Sequestration Impact: Fitch estimates that DoD spending reductions in the sequestration scenario would total nearly $1 trillion over ten years. In Fitch's view the most negative element of this scenario is an estimated 12%-13% decline in revenues in fiscal 2013, which Fitch understands would be made across the board without consideration of program health or national security priorities. This scenario could hurt financial profiles and in some cases the credit ratings of financially weaker companies.

Cash Deployment Also Drives Risk: From a credit perspective Fitch believes cash deployment is a serious risk related to defense spending reductions. Companies could pursue more aggressive cash deployment (share repurchases, dividends, and acquisitions) to offset weak growth or declines in profits. In some cases this has already started. Companies could face pressure to revise financial strategies and ratings objectives.

Pensions Could Pressure Ratings: Defense pension positions have deteriorated since the beginning of the recession. Cash pension contributions are currently high, and they should rise over the next few years. This situation is only partly mitigated by the classification of pension costs as allowable costs under government cost accounting standards.

Potential For Greater Cuts: A larger question is whether the current spending scenarios sufficiently address U.S. fiscal pressures. Defense spending will likely remain under pressure unless the threat environment changes. The U.S. defense spending outlook will be uncertain and volatile over the next one to two years regardless of whether sequestration is avoided.

Fitch will publish a more detailed report on U.S. defense spending and credit quality in the next week.

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