A version of this article appears in the August 4 edition of Aviation Week & Space Technology.
Defense company earnings reports for the quarter that ended June 30 will not be completed until the end of this week. Reports released already and the subjects of related conference calls, however, underscore three bigger themes that should continue to play out in 2014-15.
This first trend is portfolio reshaping and focus. Earlier this year, U.K. companiesand Chemring announced divestitures. This earnings season, announced it was selling DataPath, and that it was offloading AxleTech. Both businesses benefited from war-related demand for satcom services and repairs and upgrades to Mine-Resistant Ambush Protected vehicles, respectively, and had seen sales slide as demand waned. Additionally, there have been reports that is mulling the sale of DRS.
This latest cluster of divestitures is intriguing because all were purchased when U.S. forces in Iraq had peaked and forces in Afghanistan were increasing to plateaus in 2010-11. These moves suggest far less corporate confidence that the U.S. will become involved in another major ground campaign, though arguably those chances were apparent when the properties were acquired.
Defense portfolio reshaping could accelerate in 2014-15. It does not appear to be driven by a need to raise cash to pay down debt or meet other pressing financial obligations. Besides sales of businesses that have been wrung out by post Iraq-Afghanistan drawdowns, there are others factors driving defense managements to reassess their portfolios.
Outcomes of specific defense competitions for combat vehicles, fighter aircraft and naval vessels could provide one trigger as contractors reassess growth prospects in these markets. Competitive pressures in unmanned platforms, space satellites and launchers, and government services are sectors where managements may need to reassess their appetite to invest or substantially alter costs to become more competitive. Those tasks might be better performed by different owners.
Finally there is the issue of focus. General Dynamics noted that AxleTech’s defense sales had fallen to the point where commercial revenue was more important and that the company would be better off with a management focused in that direction. Rockwell Collins mentioned the DataPath divestiture as part of a plan to concentrate on “core products.” In demanding defense markets, managements need this focus to ensure core businesses can thrive.
A second trend is that while there are plenty of international opportunities, these too have risks that shareholders may not have appreciated. Managements of bothand said international sales targets will be increased. Harris discussed the strength it continues to see in international demand for tactical radios. International has been seen as a good thing by investors, but in the past quarter some nuances regarding program risk and supply chain emerged that had not been widely appreciated.
In its June quarter, Raytheon reversed some profit it had earlier realized on the Australian Air Warfare Destroyer program due to delays by its partners. Management went out of its way to state this was an isolated incident based on the structure of the contract. Still, analysts asked management questions during the Raytheon and Harris conference calls on international pricing, so there may be more concern that, along with some development risk, global market competition is stiffening.
There also was Raytheon’s comment in its conference call that investors should “view us more from a global perspective than just a domestic exporter.” This shift has supply-chain implications that could emerge as other U.S. primes seek to become more global. Some companies may benefit from this trend and in Raytheon’s case,’ role in the export of Patriot components (see photo) from Japan to Qatar is a case in point. But other suppliers could lose share as firms seek a global footprint.
A third trend is that managements called out investments they were making to win new defense business and, for the most part, spent less time enumerating cost reductions. Raytheon andexecutives discussed internal technology developments and capital expenditures for centers of excellence, respectively, that they hoped would aim to make their companies more competitive. Harris Chairman and CEO William M. Brown stated that “company funded R&D was up 30% in the fourth quarter and 12% for the year to 5.3% of total revenue, a level significantly higher than peer companies. . . .”
Some of these callouts by management may be in response toefforts to encourage contractors to spend more on independent research and development. But some managements are also signaling to investors that through these internal investments, they hope to grow and gain market share. That’s a somewhat different message than in 2012-13, when bigger share buybacks and fatter dividend payouts were seen as the way to investors’ hearts.
Contributing columnist Byron Callan is a director at Capital Alpha Partners.