Record-high operating profit margins being reported by U.S. defense prime contractors could be sustained for another year, perhaps even three, but later this decade and into next, margins may come under pressure. Of course, this has to be considered on a company-by-company basis, but there are some broader changes to consider
While there is plenty to debate about where U.S. defense budgets could settle in 2014-15, there is no debate about the Pentagon's desire to continue to compete with cutting-edge technology. It expects defense advantages to be sustained through investment in new weapons and support systems that provide a generational lead over those fielded by adversaries.
The Center for New American Security (CNAS) recently released a report entitled “Game Changers: Disruptive Technology and U.S. Defense Strategy.” That study considered additive manufacturing (3-D printers), autonomous vehicles, directed energy, cyber capabilities, human performance modification and other emerging technologies that the center believes need to be factored into U.S. security policy and planning.
Mergers and acquisitions (M&A) activity in the defense sector has been at a standstill in 2013 in the over-$100 million category. There have been several noteworthy commercial acquisitions announced by companies with defense operations: Rockwell Collins said last month it is buying Arinc from Carlyle, and Alliant Techsystems is purchasing Caliber Co. from Norwest Equity Partners and Bushnell from MidOcean Partners. But heading into September, the number of defense deals with prices in excess of $100 million is easy to add up: zero.
U.S. defense primes are reporting impressive second-quarter earnings. General Dynamics, Lockheed Martin, Northrop Grumman and Raytheon all raised guidance for 2013, and their stock prices responded favorably. The bite of sequestration—automatic, across-the-board cuts in the Defense Department's budget—has initially proved to be not as harsh as was expected earlier in the year, and operating profits are benefitting from cost-cutting. Shareholders adore the primes' share repurchase
The automatic U.S. budget cuts known as “sequestration” went into effect on March 1, but the sky has not fallen as far as investors and traders are concerned. There is no pure defense stock-price index but shares of the largest U.S. defense primes have outperformed both the S&P 500 and Dow Jones Industrial Average since March 1. Small and mid-size stocks have also performed well and even the major U.S. defense services contractors—Booz Allen, CACI, ManTech and SAIC—have seen their shares appreciate more than broader market indices.
As he was recently discussing the pivot of U.S. strategic emphasis to the Asia-Pacific region, Deputy Defense Secretary Ashton Carter repeated an assertion that the U.S. spends more on defense “than the next 16 largest militaries combined.” While Carter's talking point is more or less technically correct, such a comparison does not indicate what an appropriate level of spending should be. A more useful way to think about U.S.
For portions of the U.S. defense industry, China's military rise is viewed as an opportunity. As Beijing develops and fields more advanced defenses, the U.S. plans to respond with new spending on air, naval, missile defense and cyberforces. Indeed, this was underscored by the U.S. strategy pivot to Asia that was unveiled in January. But China's rise could also pose three challenges to U.S. defense companies in ways that may not be currently appreciated or understood.