As Sequestration Bites Deeper, How Can Defense Companies Maintain Their Results?

The Financial Times contains a story by correspondent Robert Wright today speculating that some of the Pentagon’s biggest weapons programs may escape the impact of budget sequestration. The story is well-timed because Lockheed Martin, the world’s biggest military contractor, reported second-quarter results today, and many of its competitors will disclose their own results tomorrow. Lockheed’s sales are down and its profits are up, which is a typical pattern for the early days of a defense downturn. The issue reporter Wright poses is whether some of the biggest weapons programs such as the F-35 fighter can continue to generate respectable returns even if the downturn in spending persists.

That would appear to depend on two factors. First, how do Pentagon policymakers decide to apportion spending cuts mandated by the 2011 Budget Control Act? Second, how much latitude do contractors like Lockheed have to cut costs as a way of maintaining margins? With regard to spending cuts — known generically as “sequestration” — the outlook is not good. The Pentagon’s budget request for fiscal 2014 is $50 billion above spending caps established by the deficit law, and if the law is applied as currently written then weapons accounts probably will be hit harder than other areas. With military personnel largely off the table as a source of savings, analysts expect weapons accounts to take roughly a 14% cut.

It definitely is feasible to protect a few high-priority programs such as the F-35 fighter and Virginia-class attack submarine from the effects of sequestration, by simply taking more money out of other programs. That would be especially true if Congress provided legislative relief from various overhead costs that contribute little to the final performance of the programs. And some key programs such as the Air Force’s new bomber and aerial-refueling tanker aren’t spending much money yet anyway, because they are only in the initial stages of development. The vast majority of weapons programs will have to take cuts though, and thus the impact of sequestration on returns will become increasingly apparent with each passing year.

Which brings me to the question of cost-cutting. All of the big military contractors have been cutting costs for years in anticipation of a downturn in demand, which is one reason why results at places like Lockheed Martin have held up well. But with the low-hanging fruit already plucked and most of the remaining cost structure mandated by regulations or production requirements, there is only limited opportunity for further cuts. Congress could drastically reduce the cost of developing and manufacturing weapons by getting rid of unnecessary rules, but that will require more attention than the subject is currently getting. Bottom line: contractors have only modest capacity for additional cost-cutting.

The easiest way out of this dilemma for corporate executives is to dedicate a significant portion of cashflow to stock repurchases, as Lockheed Martin already has. If companies buy back their shares at a faster pace than revenues and returns decline, then earnings per share will continue increasing despite soft market conditions. Northrop Grumman, which has already made hefty repurchases, plans to buy back a staggering 25% of its outstanding shares over the next 30 months. Thus, if it can simply maintain current levels of profitability then E.P.S. should zoom up by roughly a third because profits are being spread over a much smaller universe of shareholders. You can quibble about whether the company should have invested that money in new products, but right now the government customer isn’t funding many new starts, and the terms being offered to contractors are less than stellar.