The nation’s biggest military contractors reported third-quarter results last week, and the news was almost all good. Sales are up, earnings are strong, and the guidance to shareholders is for positive trends in coming quarters. You would never guess that the defense industry is entering the eighth year of a prolonged downturn in Pentagon demand for weapons.
But it is. In 2009, the newly minted Obama Administration canceled a slew of big-ticket programs, including the Air Force’s top-of-the-line fighter, the Navy’s planned missile-defense cruiser, and the Army’s next-generation family of networked combat vehicles. It also began a gradual withdrawal of troops from overseas war zones that resulted in the last U.S. soldiers departing Iraq in 2011. That same year, Congress passed a law capping defense spending through 2021, and weapons programs ended up providing most of the military savings mandated by the law.
So it seemed that hard times lay ahead for the defense industry. The last time there was a sizable downturn in defense spending, the ranks of top contractors were thinned by two-thirds. This time is different though. The biggest contractors aren’t just surviving, they are thriving. And Wall Street has noticed: while the Dow Jones industrial average has increased about 144% since defense secretary Robert Gates announced major cuts in weapons spending on April 6, 2009, the share prices of the biggest military suppliers have risen much more. Lockheed Martin saw its share price rise from $57 in early 2009 to $247 today. General Dynamics is up over 300%, as is Raytheon. Northrop Grumman’s share price is up 600%.
The Abrams tank has been a profitable franchise for prime-contractor General Dynamics since the Reagan years, and Army officials say it will likely remain in the force through mid-century. (DoD photo by Staff Sgt. Shane A. Cuomo, U.S. Air Force Released)
These price movements certainly don’t look like what happened in previous downturns. Explanations for why sector equities seem to have defied underlying fundamentals range from extensive cost-cutting to share buy-backs to the Fed’s low-interest rate policies. Each of those factors seems to have played a role. The top defense players have all done an extraordinarily good job of anticipating soft demand and managing their finances accordingly. But there are several other forces at work here that often go unnoticed by people outside the sector. Here are five less-noticed factors that have helped the U.S. defense industry to outperform at a time when some forecasters predicted it would be struggling.
Sector concentration. When the Cold War ended, the government encouraged the defense industry to consolidate. As a result, the top 15 Pentagon contractors in 1990 became a half dozen defense conglomerates ten years later. With so few new program starts during the Obama years, it sometimes seems that all six compete for whatever comes along. However, a closer look reveals that there are only two producers of fighters, two producers of armored vehicles, and two producers of submarines. In some cases, like aircraft carriers, there’s only one producer. Current levels of demand can’t sustain a larger number. With foreign suppliers largely excluded from the market for security reasons and barriers to entry for domestic players very high, the biggest military contractors are insulated from some of the competitive forces commercial companies must face.
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Franchise management. When a military supplier receives a contract to develop a major combat system, it in effect has been awarded an exclusive franchise that will generate cashflow for many years to come. Not only will it be the sole producer of a weapon vital to U.S. war plans, but it also has the inside track to support that system during a multi-decade service life, and to produce the weapon for export to allies. So if contractors manage these franchises rigorously, they can produce respectable profits even in downturns. Boeing’s defense operations are more profitable than its commercial transport business, even though much of the revenue comes from supporting relatively old systems. The reason Lockheed Martin’s negotiations for future lots of the F-35 fighter take so long to complete is because it is determined to get a reasonable rate of return and risk profile from its biggest military franchise.
Foreign sales. During the current downturn, the biggest U.S. defense contractors have all increased their sales of military goods and services in foreign markets. This strategy has matched up well with the foreign policy goals of the Obama Administration, which wanted allies to take on more of the security burden in their regions — and therefore recognized the need to arm them with the latest weapons. Industry bellwether Lockheed Martin disclosed in last week’s quarterly earning call that it expects foreign sales to reach 30% of revenues in the near future, up from 21% last year. Raytheon already generates nearly a third of its weapons sales overseas. General Dynamics recently saw a boost to its combat-systems operation from Saudi tank orders, and Boeing has scored major sales breakthroughs for its military aircraft during the Obama year in Saudi Arabia, India and the United Kingdom.
Political acumen. The real customer for the output of the U.S. defense industry isn’t a military service or defense agency, it’s a political system. Every penny spent on weapons by the Pentagon must be appropriated by Congress. While the budget control law passed by Congress in 2011 limits how much money can be spent in the Pentagon’s base budget, it does not limit spending for “overseas contingency operations” — meaning conflicts in Afghanistan, Iraq and elsewhere. Defense companies have become adept at shaping the composition of both the base budget and the overseas-contingency accounts to bolster spending on particular weapons. Usually these are weapons that the military services have indicated a need for, but were restrained from buying in adequate numbers by the White House budget office. Big defense companies have learned how build legislative coalitions to support their priorities.
New technology. Although cutting-edge technology often figures prominently in discussions of new weapons, few observers outside the sector have noticed how technology has transformed the way weapons are made. During the closing days of the Cold War, military-engine maker Pratt & Whitney (a unit of United Technologies) built about 50% of its parts internally. That percentage is now down to 20%, as an emphasis on core competencies and lean manufacturing led to more reliance on a rigorously-managed supply chain. But that change only became possible with the advent of information tools that enabled managers to closely monitor workflows, inventory turns, production quality and the like. Similarly, new manufacturing technologies like additive manufacturing, robotics and powder metallurgy are make production more efficient across the sector — contributing to profits.
It is nearly impossible to measure how factors like political skill and lean manufacturing have contributed to the defense industry’s resilience in the current downturn. What is clear is that the biggest defense companies have worked hard to optimize whatever resources were within their control as the political system faltered in its ability to sustain an adequate military modernization agenda. Judging from how the investment community has bid up share prices, industry has done a masterful job of managing the latest downturn.
All of the companies mentioned above except Northrop Grumman contribute to my think tank. Some are consulting clients.
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