Shareholders in aerospace and defense have never had it so good. 

The largest publicly traded companies in recent years have generated billions of dollars in free cash flow, as defined by operating cash flow minus capital expenditures, with most of it returned to shareholders in the form of dividend increases and stock repurchases. In investment circles, the strategy is commonly known as shareholder value maximization.

In most cases, it has driven companies’ market valuations to historic levels. “They’ve been monster stocks,” said Byron Callan, a director at Capital Alpha Partners, an independent strategic policy adviser to financial institutions.

In 2014, Northrop Grumman was the most aggressive, funneling $3.3 billion, or 159% of its free cash flow to investors. At General Dynamics, share repurchases and dividends consumed $4.2 billion, 131% of free cash flow; at Boeing, $8.1 billion, 123%; Lockheed Martin, $3.7 billion, 120%; and at BAE, $571 million, or 263%.

United Technologies—which last fall saw a headline-making abrupt turnover of CEOs—returned $3.5 billion, or 71% of its free cash flow. It plans to double share repurchases and increase dividends by about 8% in 2015, while drawing down research and development (R&D) spending.

The practice is not unique to the A&D industry. General Electric recently announced a multibillion-dollar share buyback plan. “It is an industry-wide phenomenon across many mature sectors—shareholders pressuring companies to return cash to them,” Callan notes. “Your primary focus becomes cash flow at the expense of almost everything else.” 

What troubles Callan and other TPC advisers—and many A&D observers, including some former chief executives—is that contractors may be shortchanging their future by under investing in R&D as the preferred means of creating long-term value. In addition, they believe the strategy of creating short-term value by returning so much cash to shareholders is simply unsustainable.

Companies are creating false expectations, according to Jacob Markish, a TPC adviser and principal of consulting firm Renaissance Strategic Advisors. “Eventually shareholders will be in for a rude awakening as companies realize they need to concentrate on more strategic, longer-term goals,” he says.

Historically, when A&D companies generated large amounts of free cash, they have tended to invest in new products and technologies, Callan points out. In the last 10 years, the focus has shifted to owners, with a huge jump in dividend payouts and share repurchases (AW&ST June 9, 2014, p. 49). In 2000, the total was less than $1 billion industry-wide, he noted. “This raises the question of whether companies’ other two constituents—customers and employees—are getting a fair break.”

Not all primes have rushed to return everything to shareholders; General Dynamics and Raytheon had been relative laggards. Last year, Raytheon returned 88% of its free cash flow to shareholders. “Management’s priority is growth, so they are stepping up company-funded R&D in such high-priority areas as cyber and “anti-access and area denial-related technologies,” according to Jim McAleese, founder of McAleese & Associates, which provides consulting and legal services to government contractors.

Raytheon Chairman and CEO Tom Kennedy told a financial conference at the end of 2014 that his company’s share repurchase program would continue, but it also planned to allocate more of its capital to acquisitions and next-generation technologies. “When defense spending rebounds, we expect our investments will be well matched with the customer’s most pressing requirements,” he said.

Still, some contractors claim the Pentagon is not providing enough incentive to justify more investment in R&D. “We don’t see many good opportunities that will generate attractive returns,” L-3 Communications CFO Ralph D’Ambrosio said at the same conference. The company returned about 117% of free cash flow to shareholders in 2014.

Raytheon has been leading some of its peers in communicating to investors that they intend to continue allocating resources toward their future while trying to take care of their shareholders, according to Markish. “As the run-up in share prices begins to taper off, other contractors will need to figure out how to prepare their investors for a shift they will have to make in their capital-allocation policy,” he says.

So-called independent R&D (IRAD) by contractors has been steadily declining since 2010, according to Tom Captain, a TPC adviser who leads the global A&D practice of Deloitte Consulting. Among U.S. companies, it fell 12.3% in the last five years, while the Defense Department’s baseline budget for research, development, test and engineering (RDT&E) dropped more than 21%.

Meanwhile, the U.S. risks losing dominance. “European companies are competing harder on pricing and advances in technology, and they have more support from their governments for RDT&E-type funding,” Captain says. The industry also is facing the prospect of increasing competition from the commercial sector.

Nonetheless, many senior A&D managers, including some who have retired, insist the industry is spending enough on IRAD, and that the real problem is the government’s lack of commitment to greater RDT&E spending.

Referring to the imbalance between short-term and longer-term capital-deployment strategies, Callan bristles at the suggestion that there are no investment opportunities. “Some of the greatest game-changing innovations in the past were created when contractors chose to accept more business risk, allowing them to conceive technologies and create new markets that previously didn’t exist,” he says.” “Some companies have lost sight of their legacy.”