Defense tech companies seek growth

REAL ECONOMY BLOG | April 18, 2023

Authored by RSM US LLP

Defense technology executives appeared pleased that Congress enacted into law the National Defense Authorization Act for 2023. But labor, parts and inflation continue to challenge their companies’ ability to improve operating margins, they said during spring 2023 earnings calls.

Multiple themes emerged from the calls, transcripts of which were provided by Bloomberg.

Customer demand is diversifying and increasing

Executives emphasized the increase in the U.S. defense budget for the 2023 fiscal year that began Oct 1. James Taiclet, chief executive officer of Lockheed Martin Corporation, said Congress’ omnibus spending bill included $858 billion for national defense, a 10% increase year over year and  6% above the president’s budget request for the Department of Defense.

Demand is also diversifying, with increased urgency from countries close to the Russian-Ukraine conflict. Phebe Novakovic, chief executive officer of General Dynamics Corporation, said that Europe is sending demand signals.

General Dynamics’ “European combat vehicle business has done quite well in securing a number of contracts, both historically, but increasingly recently,” Novakovic said.

The list of countries with demand is long and includes Poland, Romania, Switzerland, Germany, Denmark, Spain, Sweden and Luxembourg.

“The closer you are to the threat, the more urgent you feel your funding requirements,” Novakovic said.

Supply capacity is not sufficient

Defense technology executives expressed concerns about delivering on the outsize growth, due to issues with labor or parts.

Robert Mehrabian, chief executive officer of Teledyne Technologies, Inc., said supply chain constraints make it challenging to predict 2023 outcomes for short-cycle instrumentation and imaging businesses.

But most businesses are taking action to recover and improve their supply chain health. Gregory J. Hayes, chief executive officer of Raytheon Technologies Corporation, said the company has maintained a physical presence at nearly 400 supplier sites and qualifies additional suppliers for key programs.

General Dynamics’ Novakovic acknowledged that bottlenecks will persist longer than expected. She said her team has adapted to this new normal by prioritizing the procurement of key long-lead components, which can have a lead time of 12 to 24 months.

Mercury Systems, Inc. offered another example of industry resilience. Chief Executive Officer Mark Aslett said the company’s Purchasing Center of Excellence program has improved the organization’s purchasing efficiency, helping offset the effects of supply chain disruption.

Workforce issues

Some companies continue to struggle in the post-pandemic world.

Novakovic said early retirements had a disproportionate effect on additional schedule variance, resulting in late deliveries or delayed project execution.

Eric DeMarco, chief executive officer of Kratos Defense & Security Solutions, Inc., said obtaining and retaining qualified personnel remains a primary risk to the company’s pursuit of bidding and winning new programs. But he said Kratos is confident in its hiring strategy and ability to retain its workforce, and he believes it all comes down to creating a rewarding experience for employees.

“We will not stick you on this program and you’ll be on it for 40 years, and you’ll retire on it,” DeMarco said. “You come to Kratos, you’re going to work on these four different drone programs or these five different hypersonic programs.”

This type of matrix organizational structure is a shift for traditional program-oriented prime contractors, and it requires enhanced cost-accounting controls.

Rex Geveden, chief executive officer of BWX Technologies, Inc., quantified the impact of pairing a labor shortage with increased customer demand, as depicted in the following illustration:

Source: BWXT February 23, 2023, Earnings Call

Inflation

In addition to—and partly due to—capacity shortage, inflation has made improving margins even harder. Teledyne Technologies’ Mehrabian said price increases will be necessary to battle inflation.

Inflationary pressures have become a long-term struggle for organizations, and most contractors have to account for the risk in their annual operating plans. Hayes said Raytheon Technologies is taking a multi-pronged approach to addressing inflation, including higher pricing, aggressive cost reductions, process improvement and automation investments.

Many executives said the power of customers and suppliers is preventing defense technology prime contractors from growing. At Lockheed Martin, Taiclet said inflationary pressure primarily affects new proposals due to high supplier power. Suppliers are unwilling to provide long-term price agreements, or they require price-adjustment/escalation clauses to mitigate future risk.

Mehrabian addressed margin erosion, noting that Teledyne Technologies increased prices by 4%, which was offset by material and wage inflation of 4.7%. Price increases have not kept up with inflation, resulting in margin erosion. Most defense technology executives said their organic top-line growth ranged from 4% to 6%, which aligned with the year-over-year growth in the defense spending budget for fiscal year 2022. Margin growth lagged, with many leaders reporting a decrement or flat profitability. 10-K SEC filings show that most defense technology companies have a contract mix where fixed-price contracts make up more than half of their portfolio.

This complex and challenging environment for defense technology companies is portrayed in Porter’s Five Forces diagram:

In an attempt to minimize customer bargaining power, defense technology executives are pushing back on long-term fixed-price contracts and requesting adjustments for inflation.

The industry is also looking for ways to expand its supplier base, thereby decreasing the bargaining power of suppliers. Taiclet asked the government to consider the weight that oversight and compliance burdens put on new entrants and smaller entities within the supply chain.

The takeaway

Industry executives are confident in the growth and diversification of customer demand as they embrace fiscal year 2023 and beyond. But supply chain disruption, workforce capacity and inflation present risks. Industry executives seek better contract arrangements and an increase in the supplier base to balance the bargaining power of the participants in the ecosystem.

We expect next quarter’s earnings calls to address strategies to combat supply chain capacity and inflation, the president’s budget request for fiscal year 2024 and potential opportunities of the CHIPS Act.