A version of this article appears in the June 9 edition of Aviation Week & Space Technology.
Whether it is just following a herd mentality on Wall Street or because airlines, along with aerospace and defense (A&D) companies have specific reasons to try to please shareholders these days, one thing is certain: Large A&D and airline companies are returning ever-more cash to stock owners in the form of dividends and share buybacks.
But the question bubbling just under the surface is how long this situation can last.
Recently,announced a $2 billion buyback while Alaska Air Group declared that an additional $650 million will be spent the same way. Both of their stock prices have climbed over the past year, as have the values of many other publicly traded airlines, manufacturers, prime contractors and some suppliers—despite slow economic growth and headwinds such as pervasive government austerity.
The A&D sector in particular has become a virtual printing press for shareholders. Capital Alpha Partners analyst Byron Callan says buybacks totaled $6.7 billion in 2013 for(GD), , , and , for instance. While that is off their eve-of-recession record of $8.5 billion in 2008, Callan expects a new record soon despite higher prices.
“Stock prices are substantially higher in 2014 than 2008 and yet primes appear on track to easily smash the 2008 pace of buybacks,” he says.
Similarly, in his own recent report, analyst Russell Solomon of Moody’s Investors Services says, GD, Raytheon, Lockheed and Northrop together increased dividends by 23% on a Moody’s-adjusted basis, while share buybacks rose more than five-fold. Again, all this action occurred as prices remained near 52-week highs.
Callan does not believe this pattern of more cash flowing to shareholders is unique to airlines and A&D, and he suspects that data for most large U.S. public companies show similar paths. Still, he, Solomon and other analysts suggest the high level of cashing-out is one indication of persistent and widespread uncertainty over where business is heading as Western combat operations draw down in Afghanistan and recession-borne fiscal austerity measures remain largely in place.
In Solomon’s report, he notes how higher shareholder returns is not the only major trend to emerge from recent first-quarter results. So, too, are declining defense revenue and—in most cases—improved operating margins. While the first and last trends may seem promising on their own, Solomon says the three together could be red flags for investors.
In the first instance, defense-related revenue keeps falling because of government austerity measures. While a late-2013 compromise in Washington ameliorated so-called sequestration cuts through fiscal 2015 and provided a two-year window of forecast stability for federal contractors, companies are merely in the early days of feeling the effects of cuts because outlays—contract awards and payments—lag lawmaking. Solomon says defense primes will continue to see mid-single-digit revenue declines through at least the end of the year.
Sequestration cuts, nevertheless, grow again in proportion starting in 2016 and remain in place through early in the next decade, under current law.
Second, because federal contractors saw sequestration coming, many made preemptive cuts to their businesses. Since companies can move quicker than sequestration’s effects, many entities have recorded higher profit margins. Accounting maneuvers such as harmonization of pension-plan funding requirements and cost-accounting standards for government contracts also have provided short-term boosts to margins and cash flows, Solomon says.
At the same time, A&D companies shied from major mergers or acquisitions while government spending and priorities were nebulous, keeping more cash for popular uses like returning it to shareholders and underpinning stock prices. Not even the leading Pentagon contractor expects another option on the horizon (see chart).
“We do not automatically drop to the fact that we need to be buying back shares and that it is the best use of capital,” Lockheed Chief Financial Officer Bruce Tanner said while discussing first-quarter results. “We actually do look at growth opportunities,” he says of mergers and acquisitions. “But honestly, as we look at the environment right now, there is not enough of those to justify the ample cash that we are throwing off as a very mature business and in the environment we are in, from an overall budget perspective.”
But industry will find that maintaining the rate of internal cuts will be difficult, and margin expansion will be harder to sustain as competition intensifies for scarcer government dollars, Solomon and others say. Likewise, companies risk downgrades from credit-rating agencies if they try to sustain flush shareholder returns while everything else is dropping.
Says Solomon, “Margin improvements and more certainty in recent months with respect to near-term budgets definitely got the defense industry feeling better, but we still see more clouds than blue sky ahead.”
|Dividends Per Share||Stock Prices (High-Low)|
|First||$1.15||$1.00||$96.59 - 85.88||$91.01 - 79.05|
|Second||1.15||1.00||109.26 - 94.00||92.24 - 80.14|
|Third||1.15||1.00||131.60 - 105.54||93.99 - 83.15|
|Fourth||1.33||1.15||149.99 - 121.52||95.92 - 87.08|
|Year||$4.78||$4.15||$149.99 - 85.88||$95.92 - 79.05|
|Source: Lockheed Martin|