With European economies slumping anew, investors have been figuring out ways to trim their exposure to that region. Business conditions are weak and could spiral even lower in coming quarters before an eventual rebound. That's why I wrote this article, which says that you should revaluate holding shares of U.S. companies that derive more than one-third of their revenue from Europe, as it may see sales fall below forecasts in coming quarters.
Yet Europe isn't the only concern. In roughly eight months, another major source of revenue may experience real trouble. Of course, I'm talking about the U.S. government, which is on the cusp of a major pullback in spending so that it can get the federal budget into balance.
If legislators fail to hammer out more agreements on when and where to cut, then automatic cuts will begin. For example, the Department of Defense is scrambling to adapt to the possibility that a cumulative $492 billion in spending cuts will take place through 2021. Lawmakers may decide to instill less draconian cost-cutting, but it's increasingly clear that defense contractors will probably be chasing a smaller pie of revenue.
These defense contractors have been scrambling to line up foreign customers, but have only made moderate headway: Raytheon (NYSE: RTN), SAIC (NYSE: SAI), Northrup Grumman (NYSE: NOC), Lockheed Martin (NYSE: LMT) and L-3 Communications (NYSE: LLL) all derive more than 80% of their revenue from Uncle Sam.
Meanwhile, investors have poured back into defense stocks, figuring they are inexpensive based on 2012 sales and profit forecasts. But with zero or even negative growth prospects, they aren't a bargain at any price.
As of now, the Department of Defense looks set to shrink 3% to 4% in each of the next five years. This doesn't even include spending drops associated with the U.S. troop withdrawal from Afghanistan. Whether these cuts are more focused on personnel or equipment remains to be seen, but the leading defense contractors are vulnerable because they are counting on expensive plane and ship programs that may get the budget ax.
Health care spending will plunge
It's not just defense stocks that will feel the pain of reduced government spending. As of now, Uncle Sam will make an equivalent $492 billion in cuts in other parts of government as well. Again, lawmakers may manage to come to an agreement, averting these massive cuts, but investors should expect at least some degree of spending cuts.
At least 40% of the currently planned $984 billion of cumulative spending cuts through 2021 will be borne by the health care industry. Regardless of how the Supreme Court rules on the issue of President Obama's health care plan, spending cuts are coming.
A decade of rising costs has been great for drug companies, insurers, hospital operators, software supplier and many other players in the industry. The coming decade should represent a reversal of fortune for them as pricey drugs, six-figure surgical procedures, diagnostic testing services and extended patient stays within facilities are just some of the areas slated for cutting.
Companies at risk: Insurer Humana (NYSE: HUM) derives roughly 75% of revenue from Medicare and Medicaid reimbursement; Dialysis services firm DaVita (NYSE: DVA) gets 66% of revenue from the government, while this figure stands between 40% and 50% for Tenet Healthcare (NYSE: THC) and United Healthcare (NYSE: UNH).
And there's more...
The for-profit education sector is hugely vulnerable in light of the growing debate of whether these institutions are delivering a sufficiently robust education for the tuition they charge. Some lawmakers hope to see reduced government support for student loans, which would lead to drops in enrollment for these institutions. DeVry (NYSE: NYSE: DV), for example, has 80% of its revenue base tied to government-sponsored student loans. This figure is more than 30% for the Washington Post (NYSE: WPO), which runs the Kaplan Education services division.
Lastly, companies that sell products to government research labs are quite vulnerable to a spending drop as well. These include Life Technologies (Nasdaq: LIFE), Thermo-Fisher (NYSE: TMO) and Sigma Aldrich (Nasdaq: SIAL).
Risks to Consider: As an upside risk, government cuts won't be nearly as severe if lawmakers instead decide to largely focus on tax increases to close the budget gap, which looks awfully unlikely.
Action to Take --> Many of these companies lack visibility into the long-term ramifications of a smaller government, and instead are relaying what business conditions look like right now. Investors would be wise to exit any government-focused stocks before the topic becomes more widely discussed in investment circles and share prices plunge.