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  • Defense Disconnect: Lean Times, Fat Profits
    Posted by Joe Anselmo 7:34 PM on Feb 06, 2012

     Are defense contractors earning too much money in an era of budget austerity? That question is being asked at the Pentagon after earnings results showed the industry managed to maintain and in many cases bolster profit margins in 2011, even as growth evaporated.

    General Dynamics’s Combat Systems unit raised its operating margin to 14.5% on a 1% sales decline.  Raytheon’s Integrated Defense Systems—which generates fat profits from foreign military sales—turned in a 16.9% margin for the year despite a 9% sales dip. Lockheed Martin’s  Space Systems, which has a lot of low-risk, cost-plus contracts, reported a 12.2% margin on 1% lower sales. And Northrop Grumman’s  Aerospace Systems and Electronic Systems raised margins to 12.1% and 14.5%, respectively, shrugging off sales declines of 3-4%. “The pattern continues—defense revenues light, defense margins strong,” says RBC Capital Markets analyst Robert Stallard. “With volumes heading down and the customer tightening the terms, we shall see how long this situation can last.”

    Until a decade ago, the margins of military contractors averaged about 8%, according to James McAleese, a consultant to both defense contractors and the Pentagon. That changed when the war against Al Qaeda and the U.S. invasion of Iraq unleashed a torrent of new spending. (For a little perspective, Boeing’s Commercial Airplanes unit reported an operating margin of 9.7% in 2011, while Airbus’s  commercial unit generated a 1.5% margin in the first half.) “It’s not that defense contractors are gouging the government,” says McAleese. “But it is clear that on previously negotiated contracts, they are cutting costs faster than the revenues are falling.”


    Indeed, industry veterans argue that the higher profit margins are the result of aggressive cost reductions and layoffs that companies have made to prepare for leaner days ahead. They predict that margins will come under more pressure as multi-year contracts awarded during boom times run out and are succeeded by new awards with less generous terms.


    That already has started. As new programs become scarcer, competition among contractors has grown fiercer. For example, Boeing’s winning bid of $31.5 billion on the U.S. Air Force’s tanker contract last year was more than $10 billion lower than its original bid in 2008. And as the Defense Department grapples with budget cuts that could top $1 trillion over 10 years, it is demanding that industry absorb a much greater share of the risk in developing new systems. “There is no doubt, based on where the Defense Department is going now, that margins will start coming down,” says McAleese.


    It is little wonder then that companies such as Raytheon and L-3 Communications are warning Wall Street that profit margins will be slimmer this year. “Companies have had 10-plus years of great times,” says one longtime investor. “They’re squirming like fish in a lake that’s drying up.”

    Tags: AR99, AWCOL

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