A funny thing happened on the way to the aerospace and defense industry’s maturation. The companies became good businesses—maybe too good.

Twenty years ago when Aviation Week started its annual review of Top-Performing Companies, the concern was that Western A&D companies did not operate well as businesses, at least not compared with other sectors and Wall Street benchmarks. While they provided amazing weaponry, airliners and spacecraft, when it came to operating performance, A&D enterprises seemed to lag by decades automotive, oil and gas, and other industries in basic business prowess.

A look at this year’s TPC rankings and results indicates they have learned their lessons well. Not only did A&D as a whole post record revenue for 2014, but many companies simply became operationally better. What is more, this change came about despite two years of so-called sequestration spending restraints, the historical halving of the price of a barrel of oil, the dramatic strengthening of the U.S. dollar, airliner disasters and international volatility such as in Ukraine.

“The core of the big primes and the U.S. defense industry continue to do really well despite all the angst and observable trauma,” says TPC adviser Jacob Markish, principal at Renaissance Strategic Advisors. “Another measure that was unsurprising is that the well-focused and disciplined mid-tier, whether in electronics or in one of the commercial parts of the components sector, continues to do very well.”

Above all, the record up-cycle in commercial aerospace, led by the now nine-year backlog of large airliner orders, continues to drive up the whole sector. “The story last year, in 2014, was commercial,” says Tom Captain, vice chairman and global A&D sector leader for Deloitte and a TPC adviser. “The story will be the same in 2015. There is no bubble.”

TPC rankings of publicly traded A&D contractors are the result of composite scoring of four equally weighted performance categories that place significant emphasis on operating excellence. They are: return on invested capital (ROIC), measuring investment decisions; earnings performance, i.e., revenue quality and expansion; asset management, or how efficiently a company employs its resources; and financial health, as in a company’s strength, including overall solvency.

In turn, the TPC council of advisers this year identified several common attributes among companies that can claim success in the rankings. For starters, A&D companies appear better managed from the top down; even defense units are run as much like commercial operations as possible. Next, companies are increasingly focusing on areas of expertise, becoming dominant players in niches and shedding non-core operations.

“The thing that keeps coming back at me, year after year, is the companies that do well have a proprietary position; they know what business they’re in,” says Harlan Irvine, a TPC adviser and Deloitte principal. “The folks that have a defensible position, either they own a program of record or they own intellectual property that they can lever. They do a decent job of running the business according to the levers that are relevant.”

In defense, companies are trying to develop or harness commercial technology—like Rockwell Collins and its Pro Line Fusion avionics—to the extent possible rather than the Cold War approach of government-first. And, paradoxically, when focusing a company, Top-Performing Companies are buttressing revenue by diversifying customer types and sources, such as by boosting international sales, finding new clients for current offerings, and even tiptoeing into adjacent markets.

Surpassing these trends, however, is the idea that the companies in general are leaner, more efficient and more productive, per worker. If possible, major assets and inventories are placed or left in the hands of others, e.g., shipyards with the government instead of defense shipbuilders, or Tier 1 aerostructure providers instead of the nameplate original equipment manufacturers (OEMs). Liabilities such as pensions, once proverbial albatrosses around the neck of industry, are being optimized. Finally, free cash flow, the money generated and left over after assets are dealt with, is maximized and most of it is returned to shareholders and investors.

“It has to do with the treatment of assets,” says Steven Grundman, a TPC adviser, George Lund Fellow at the Atlantic Council, and former assistant secretary of defense for industrial affairs and installations. “Utility-style companies that manage assets well and generate cash succeed in this model. That does not tend to be a thing we all celebrate.”

For John Stack, managing director and aerospace leader at the McLean Group, and other advisers, the true measure of a company is in what it makes beyond the financial reports. What the numbers show and what industry executives and analysts can point to can be different and worthy of consideration. “It should be about value creation,” he says.

Take Boeing, which won both its TPC category ($20 billion or more in annual revenue) and scored the best among all companies (97 this year, and a five-year average of 93). Captain points out that the leading OEM looks to be on the verge of reaching $100 billion a year in revenue in a couple of years, and maybe even next year when the company marks its 100th anniversary. If no new airliners were ordered this year due to a cataclysmic event—think a 9/11-type terrorist attack or pandemic flu, which shuts down air travel—the backlog would slip to just an eight-year wait-list.

“Boeing is a fundamentally unique company,” Markish says. “Their commercial operations . . . effectively constitute half of a hugely valuable duopoly and [it] has consistently known how to make money.” -Results from 2014 do not represent a new era or new direction “It is -business as usual at a macro level.” 

Yet while the OEM and Pentagon prime is eyeing or pursuing new programs like a “middle-of-the-market” 757-replacement airliner or the U.S. Air Force Long-range Strike Bomber, these are seen more as derivative innovations. Boeing Chairman and CEO Jim McNerney last year famously declared no more “Moonshots” when it comes to development efforts, and the company has been reaping the benefit of its steady market dominance for years.

TPC advisers recognize that it took Boeing a lot of investment and innovation—as well as some course corrections—to reach this point. Five to six years ago, the company’s problems with major programs and customers were headline news, and TPC advisers at the time criticized both management execution and program performance. Now it is “smooth sailing,” one adviser says.

The company is not only reaping the benefit of earlier investments and corrective actions, the learning curve is being extended into other programs. In February a reorganization of Boeing Defense, Space and Security was announced that resulted in a new entity—the BDS Development office. Modeled after a similar unit in Boeing Commercial Airplanes, the office “will address development risks and affordability.” Six programs now managed elsewhere in BDS will be the first to be overseen by BDS Development, including the USAF KC-46 aerial refueling tanker and NASA Space Launch System rocket. 

Still, for an industry that can claim hypersonic vehicles, landing humans on the Moon, and helping to build—here in the U.S.—what is arguably the most powerful military on Earth, the emphasis on shareholder value maximization and relatively lower independent research and development are less inspiring to many observers. It also comes as Pentagon officials are pushing their so-called Third Offset strategy for technology development, with a soon-to-be-unveiled Long-range R&D Plan crafted with industry in mind.

TPC advisers such as Byron Callan, a director at Capital Alpha Partners, say they see potential changes coming to industry’s makeup as managers and directors shift their focus to longer-term positioning. In 2016-18, the “overwhelming” investor focus on defense contractor capital deployment could give way to accommodation of the Pentagon’s changing acquisition practices and emerging competition.

“Managements that do not make strategic decisions on their participation in defense but overwhelmingly deploy capital in favor of shareholders could be caught flat-footed by these changes,” Callan cautions.

Stock agrees: “You can only lever to pay buybacks and dividends and everything else for so long. You can’t save your way to greatness.” 

Top Performing Companies Extras
Subscribers to the Aviation Week Intelligence Network can access:

-- Rankings of A&D companies with revenues between $250 million and $1 billion
--  Detailed interactive charts of TPC-ranked companies with links to spreadsheets
--  Rankings of more than 100 A&D business segments in 14 categories