The third-quarter reports did show increasing and worse-than-expected pressure on sectors of the defense business that are focused on providing services rather than products.
Classic service providers such as CACI Inc (CACI.N), Mantech International Corp (MANT.O), and Science Applications International Corp SAICI.UL are the hardest hit so far, but even the service divisions of Lockheed, Northrop and other big firms reported lower margins, Stallard said.
General Dynamics Chief Executive Jay Johnson told analysts it was “a blinding flash of the obvious” that his company was seeing the most impact on margins in its information systems sector, where services account for about half of revenues.
“There’s a margin reality that’s attached to that,” Johnson said. He said that sector has just won some significant contract awards that would help improve margins, but program managers are insisting on more competition, scaling back contracts, and awarding contracts by assessing the “lowest price, technically acceptable” bid, rather than “best value.”
Defense consultant Loren Thompson of the Lexington Institute said the companies had been preparing for the downturn for years, taking aggressive cost-cutting measures like closing plants and laying off workers to preserve profits, while maintaining solid dividends and buying back shares.
Eventually, Thompson said, cost-cutting efforts will reach a limit since it will get harder and harder for companies to find efficiencies on a dwindling number of programs.
“There’s a fine line between cutting unnecessary costs and beginning to undermine future business prospects,” he said, noting that scaling back research and development spending or marketing would eventually eat into a company’s ability to respond to rapidly changing military requirements.