This article originally appeared in the April 21 edition of Aviation Week & Space Technology.

Why are defense contractors investing so little in their future? That question is moving front and center as a budget squeeze forces the Pentagon to curtail R&D investments that underpin the industry’s product lines.

What a curious downturn it has been. Even as sales contract, defense primes are posting record profit margins (AW&ST April 7/14, p. 18)—and Wall Street has rewarded them amply. Consider that while the Dow Jones Industrial Average rose 26% last year, shares in Northrop Grumman were up 74%, Lockheed Martin 68% and Raytheon 62% (see table). Yet contractors are reinvesting little of those profits: R&D equaled just 1% of sales at General Dynamics in 2013, 1.5% at Lockheed and 2% each at L-3 Communications, Northrop and Raytheon. That is well below the 3% considered the norm a decade ago.

R&D Investments
and Stock Performance

 

 

 

Company

R&D as 

Percentage 

of Revenue in 2013

 

Stock Price 

Increase

in 2013

Harris

  20%

  47%

Teledyne

17

41

Rockwell Collins

6.3

29

BAE Systems

6.2

32

Saab

5.6

31

Airbus Group

5.3

96

Thales

4.7

83

Boeing

3.5

85

Northrop Grumman

2.1

74

L-3 Communications

2.0

43

Raytheon

2.0

62

Lockheed Martin

1.5

68

General Dynamics

1.0

40

Sources: Aviation Week Top-Performing Companies database,
Yahoo Finance. 

 
   
   

In a meeting with Aviation Week editors, William Lynn, a former U.S. deputy defense secretary and now CEO of Finmeccanica North America, lamented that the primes remain focused on bolstering their share prices through stock repurchases and raising dividends, rather than investing more in next-generation, disruptive technologies that will be critical to future competitiveness (see page 52). He notes that even if the R&D budgets of the top five U.S. defense contractors were combined, they still would not rank among the 20 biggest industrial R&D spenders worldwide.

The problem is compounded by cuts in government spending at the same time: The Pentagon’s investment in research, development, test and evaluation has fallen 28% since its peak in 2009, adjusting for inflation. That has implications for both the nation and its defense industrial base. Frank Kendall, the Pentagon’s acquisition chief, warns that rising investments by China and other nations threaten to erode the technological superiority the U.S. military has taken for granted for decades.

To be fair, U.S. defense primes have traditionally counted on the government to fund the bulk of weapons system research and, in return, have limited their profit margins. That arrangement worked fairly well for a long time, but it’s beginning to break down. One culprit is a dysfunctional Congress that treats military spending like a political football. 

“In the past, a company could see the programs coming,” says Michael Goldberg, who leads Bain & Co.’s global aerospace and defense practice. “You had a reasonable expectation that if you invested in a technology and it worked out, it would pay for itself. Today, even if the customer says it wants something there is no guarantee it will be funded.”

That is not to let industry off the hook. Its focus has skewed too much toward satisfying investors in the near term, and board members know it. “Contractors are struggling with this,” notes Byron Callan, a defense analyst at Capital Alpha Partners. “It may come down to how much risk they see” of a shareholder backlash if higher R&D investments depress margins.

To be sure, it is unrealistic to expect publicly owned companies to make open-ended investments in Darpa-like “science projects.” That remains the government’s responsibility. And while increased focus on innovation sounds like a no-brainer, the logical outcome is that current products are replaced with new and better ones—which is where things can get tricky. “I’m sure Lockheed Martin, the Air Force and the Marines support R&D in theory,” says Callan. “But if [the Pentagon] cuts back the F-35 buy by 20% to carve out R&D funds for new unmanned systems, the reaction would be anything but tepid.”

USAF Gen. (ret.) Chuck Wald, federal practice advisory partner in Deloitte’s government services business and a former deputy commander of the U.S. European Command, says it doesn’t have to be an either-or choice. He believes the Defense Department could find billions of dollars for increased R&D investments through force structure cuts and by implementing more efficient practices, such as performance-based logistics and cost-effective data storage. And Goldberg explains that defense contractors need to figure out how to partner with commercial technology companies “because that’s where all the innovation is now. If Google and Amazon are serious about creating a family of drones, they could come up with much more practical products quickly.”

Defense contractors will also have to be less averse to taking risks. Saab’s JAS 39E Gripen has emerged as a serious lower-cost contender in the fighter jet market, and the Swedish company has staked a lot on its future. Saab’s investment in R&D last year: 5.6% of sales, well above its U.S. peers.