Prime contractors show strong earnings despite sequestration

Tuesday - 7/30/2013, 10:45am EDT

Michael Lewis analyzes sequestration and prime contractors on In Depth with Francis Rose.

Download mp3

In a time of furloughs and sequestration, prime contractors seem to be faring well and unaffected by budget cuts.

"All of the earnings reports that we've seen from the large prime integrators have been very strong. They have certainly surpassed expectations," said Michael Lewis, chartered financial analyst and co-founder of the Silverline Group. He spoke to In Depth with Francis Rose Monday as part of Federal News Radio's special report, Private Side of Sequestration.

Prime contractors such as Lockheed Martin, General Dynamics and Raytheon had very strong showings in their earnings reports, Lewis said. "While revenue was a little bit light, most of these companies had blowout margins, strong [earnings per share], and their mix continued to be very good with solid execution. So, we're not really seeing the impacts of sequestration appear on target."

Michael Lewis, chartered financial analyst and co-founder of the Silverline Group

"What we've seen over the last few years are significant changes in the cost structure of these primes," Lewis said. "They have been very successful in driving those cost savings down to the bottom line — that's why the margins continue to improve quarter over quarter."

But the strong earnings reports might be misleading.

"The reason why the primes are holding up very well is because of the longer duration of that revenue," Lewis said. Pure-play government services firms, on the other hand, have a high proportion of their revenue tied to one-year money.

A great portion of prime contractors' revenue is generated by funds from procurement and research and development accounts, which tend to be longer duration funding profiles. In the case of Lockheed Martin, a large percentage of its revenue is tied to weapons manufacturing, which also involves long-term funding. The revenue contributes to high levels of funded backlog, which is money in hand on contract.

"We are paying most of our attention to funded backlog levels ... that's what we're tracking to provide us with visibility into the revenue streams," Lewis said. "I think that's the best gauge for both industry and investors to focus their attention, because that is really the tell on whether the business is turning toward the downside or able to maintain stability."

Lewis anticipates that sequestration will eventually cause negative trends to start showing and funded backlog levels to weaken.

"Once we get into a few quarters in this current sequestration environment, we'll start to see their results worsen. They're just so big that it hasn't happened yet with the primes," he said.

As results worsen, the most successful companies will be those who take the greatest market share. The firms that have "strategic guides, real core focus in their market are going to perform well, even in this environment," Lewis said. "$40 or $50 billion cuts, it's still a lot of money. Everyone's going to feel a little bit, but the question is, 'Who feels the most?' And that is still yet to be seen." MORE FROM OUR SPECIAL REPORT, PRIVATE SIDE OF SEQUESTRATION:

Part 1: Contractors confronted with new type of waiting game due to sequestration

Part 2: Federal 4th quarter spending spree offers contractors hope for return to normalcy

Part 3: Sequestration plays second fiddle in aerospace industry to previous cuts

Part 4 Prime contractors show strong earnings despite sequestration

Part 5: Contractor hiring, morale take sequestration hit

Part 6 : Small contractors struggle from, rise to the challenge of sequestration

Part 7: Planning for the worst: Companies aim for sequestration-easing strategies

Part 8: Small firms feel first bite of DoD budget cuts as large contractors' stock soars

Part 9: Contractors adapting to post-sequestration environment

Part 10: Fed furloughs leave imprint on procurement process, contractors say

Survey: Contractors speak out about sequestration's impact

Data Analytics: Sequestration's impact on contractors by-the-numbers

Column: Sequestration creeps outside the Beltway

Audio Interview: Government market ground zero