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.

Before assessing where operating margins could go, it’s useful to consider where they have been and why they have improved. The percentages of operating margins before pension expense or income have moved from the mid-upper single digits in the 1970s-80s to the 10-12.5% range in 2013. 

This improvement was driven by several factors. Consolidation in the 1990s created larger, more diversified primes that don’t have to bet on winning major programs that make or break core defense franchises. The days when companies were run by their founders are long gone, and incentives for top executives have shifted decisively in favor of creating “shareholder value.” Company-funded R&D, as a percentage of sales, has declined.

There are not many new starts for major weapons programs, and few primes are willing to emulate Northrop’s F-20 program to develop a new aircraft independently, without government backing. Finally, the Defense Department and industry have been more disciplined in using fixed-price development contracts, which had contributed to some of the big earnings blowups.

Absent moves by the Pentagon to shift more risk onto contractors, margins should remain strong into 2015 as primes reduce costs and change their mix of programs. However, there are several factors looming that could place more pressure on margins by the end of this decade. 

The first is that the Truth in Negotiation Act will require cost savings on fixed-price contracts to be disclosed to the government and factored into negotiations. For companies selling products under commercial contracts this not an issue, but as current fixed-price contracts roll over and new ones are negotiated, firms have to disclose their costs to the Defense Department. Margin bump-ups from facility and employment contraction may thus prove fleeting. 

A second issue to watch is how primes seek cost reductions from suppliers. Boeing’s Partnership for Success is one example of a corporate-wide initiative to drive down supplier prices. But as the automobile industry learned the hard way, heavy-handed mandates for price cuts can backfire and force suppliers out of the defense markets or cause program disruptions and execution shortfalls.

A third issue is program mix. Current Pentagon investment plans focus on higher production rates from programs now in their later stages of development. However, if adversaries and competitors can press ahead and field weapons systems that are as advanced as those of the U.S., current programs of record may be challenged by new requirements and new starts. 

The Defense Department’s funding for research, development, test and evaluation has declined significantly since the mid-2000s. These declines translate directly into the number of engineers employed by defense contractors and it’s a fair assumption that the industry faces greater competition for new engineering talent from commercial technology companies than in the 1960s-80s. Thus, if external security threats and internal budget dynamics accelerate change within the department’s acquisition plans, current contractor profits may be at greater risk on the basis of their ability to execute these new programs.

A fourth risk for defense primes is emergence of non-traditional competitors who are more willing to invest their own funds to bring new product to market faster than current department development cycles. These companies may be private or have engineer-founders who think very differently about the time frames and mechanisms over which “shareholder value” can be created.

The fifth risk is that Defense Department or congressional attitudes will change regarding allowable costs, competition or risk that is shared with contractors. Right now, there is little sign of this sort of change, with the department’s leadership aligned with the notion that good performance merits attractive returns. But these attitudes have changed during the course of defense cycles, and could change again. 

 


Contributing columnist Byron Callan is a director at Capital Alpha Partners in Washington.