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19 January 2015

Strength of the US Defense Industry

Philip Finnegan, Director, Corporate Analysis

Despite its current strength, the US defense industry faces serious is sues for its future international competitiveness. The challenges stem from changes within industry itself and from US government policies.

One of the major changes in the outlook for US industry comes from the change in culture in the industry towards an increasingly short-term focus. Now there is a serious effort by defense companies to turn much, if not all, of their available cash flow to stock purchases and dividend increases. The result has been that defense stocks have out per formed the over all S&P 500 for the past decade. That is increasingly difficult to change as time goes on and shareholders grow to expect it and the industry attracts a shareholder base that relies on a high yield

Cash re turns to shareholders have in creased over the past decade and be come increasingly aggressive. For example, Northrop Grumman reduced its out standing shares by a third shares in the period from 2008 to 2013. The company also plans to buy back an other quarter of its shares by the end of 2015 at a cost of $4 billion.To do this, it will use cash, free cash flow and may even is sue debt. This may be some what more aggressive than other leading companies, but not terribly. Lockheed Martin, Raytheon and General Dynamics have all been reducing their share count though buy backs.

In the past, some companies have been successful in developing defense systems at company expense that can then be sold on a commercial basis to US and international customers. For example, Harris developed its Falcon software defined ra dio in this way. That approach of ten paid off in earn ing higher profit margins when many countries, including elements of the US military, adopted the Falcon III to compensate for the failure of the Department of Defense-funded Joint Tactical Radio System. Now

Harris is increasingly focusing on returning funds to shareholders.

Ex ec u tive com pen sa tion is now more aligned with stock per for mance than in the past, giv ing chief ex -

ec u tive of fi cers in cen tives to con tinue ag gres sive buy backs and div i dends at the ex pense of the cap i tal

spend ing and com pany-funded re search and de vel op ment spend ing needed to in vest in the com pany's

fu ture. In ad di tion to cuts in re search and de vel op ment spend ing over the past de cade, there has been a

shift to wards spend ing funds on pro jects with more im me di ate pay offs such as bid and pro posal costs.

Com pare this with the be hav ior of Gen eral Atomics Aero nau ti cal Sys tems that is pro duc ing a stream

of prod ucts at its own ex pense to re tain its lead er ship of the me dium-al ti tude, long-en dur ance mar ket.

It de vel oped the Pred a tor XP, a stripped down ver sion of the Pred a tor, spe cif i cally for in ter na tional

mar kets that would face ex port prob lems oth er wise. The com pany also has de vel oped a se ries of pro -

to types over the years that have shaped US mil i tary re quire ments for un manned sys tems and were

even tu ally pur chased by them. Gen eral Atomics is pri vately-owned so the fo cus is on de vel op ing for

the long-term rather than short-term stock prices.

Re cruit ing tech ni cal tal ent into the de fense in dus try is be com ing more dif fi cult. In creas ingly, com -

mer cial com pa nies are of fer ing op por tu ni ties in sim i lar ar eas such as cyber, elec tron ics and aero -

nau tics. With greater pros pects for growth and a more flex i ble work en vi ron ment, it be comes

dif fi cult for the de fense in dus try to at tract the tal ent it needs. The ex trac tion of cash from de fense

busi nesses and ag gres sive cost-cut ting serve to ag gra vate the dif fi cul ties in at tract ing tal ent.

The low lev els of re search and de vel op ment spend ing and dif fi cul ties in re cruit ing tal ent, threaten to

un der mine the de fense in dus try's abil ity to com pete in very ac tive, dy nam ics area of in dus try, such

as cyber, un manned ae rial ve hi cles and com mu ni ca tions. In creas ingly de vel op ments in those fields

will come from com mer cial com pa nies in an in creas ingly glob al ized mar ket.

The prob lems are not only with in dus try pri or i ties. The US gov ern ment's fail ure to stick with

long-term plans to re ward risks is well known. The Un manned Car rier-Launched Air borne Sur veil -

lance and Strike air craft pro gram has at tracted con sid er able re search and de vel op ment fund ing from

lead ing de fense con trac tors, but is now be ing de layed an may ul ti mately cancelled. Of course, the

con tin u ing shifts in ser vice pri or i ties only re in force in dus try's in ter est in avoid ing risk by not us ing

com pany funds to in vest in programs.

US ex port re stric tions are a se ri ous im ped i ment to US in dus try's abil ity to make ex ports and co op er -

ate with in ter na tional in dus try. Con tin u ing ef forts to re form the reg u la tions stream line them, but re -

tain tough re stric tions. This has al ready fos tered the growth of ITAR-free European sys tems in ar eas

such as sat el lites and unmanned ae rial vehicles. The goal is to avoid the complications and de lays of

deal ing with the complexities and restrictions of US ex port regulations.

There is a need to build in exportability early in the pro cess. The Pen ta gon is work ing to try to con -

sider this by mak ing exportability a pri or ity in the de sign of some weap ons sys tems. That will in -

volve add ing anti-tam per char ac ter is tics ear lier to limit their cost. In a first, there is a Pen ta gon

de sign for affordability pi lot pro gram for the US Air Force Three Di men sional Ex pe di tion ary

Long-Range Ra dar. This is the first De part ment of De fense ac qui si tion to in clude an exportability

de sign re quire ment. There is an other pi lot pro gram for the Navy's Next-Gen er a tion Jammer.

Yet it is im por tant to re mem ber that this prog ress is on the fringe. Gen er ally mil i tary ser vices con -

sider their re quire ments with out any con sid er ation of whether sys tems can be ex ported.

Un for tu nately this is no guar an tee that affordability will be ad dressed. The United States has weap -

ons sys tems that were de vel oped with the US mil i tary in mind. Cost was a low con sid er ation as the

pri or ity was placed on per for mance. The re sult is that many of these sys tems such as Global Hawk or

the F-35 Joint Strike Fighter be come af ford able to a very small num ber of coun tries, leav ing the

wider mar ket open to lower cost alternatives.

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About the Author

Philip Finnegan

Philip Finnegan

Phil is Director of Corporate Analysis at Teal Group. He has provided strategic and market analysis for clients in commercial aerospace and defense, including major U.S. and European prime contractors, since joining Teal fifteen years ago.

He also writes and edits Teal's Defense and Aerospace Companies Briefing, which analyzes the performance, outlook and strategies of 50 aerospace and defense companies in the United States, Europe, Asia and South America. He is a co-author of the annual World Unmanned Aerial Vehicle Systems with responsibility for UAV companies.

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