A Wall Street research firm says defense contractors should be able to maintain their profit margins even as Pentagon spending declines.
“Over the last two years we have heard investors concerns that defense margins will contract because of declining budgets and Pentagon efforts to cut costs,” says a Bernstein Research report issued May 18. “But this has not happened, and we do not expect it to going forward.”
The report, written by a team led by analyst Douglas S. Harned, argues that defense investment accounts are shifting toward higher-margin production and away from lower-margin development. International sales – which usually command fatter profits – are growing. Consolidation has left fewer contractors bidding on work than in past downturns, which limits price competition. And while contractor structures are putting more risk on contractors, the industry is unlikely to see a return on all contracts to firm fixed-price developments, the report argues.
The Bernstein team even found a silver lining in deep automatic defense cuts that are scheduled to take effect next January under a process known as sequestration. “The threat of sequestration is now becoming a benefit, as management teams use it to create an imperative for cost reduction,” the report says. The analysts also believe that lawmakers will ultimately reach a deal to avoid sequestration, “though we may see a tense period in December and January.”
That’s not to say that all contractors will be immune to the leaner budget environment. Companies heavily exposed to Army ground procurement will see high-margin work go away as the U.S. completes its drawdown from Iraq and Afghanistan. And the Bernstein team expects government services to remain a highly competitive – and low margin – business.
But the report finds that defense unit margins have risen since 2009 at Lockheed Martin, General Dynamics, Northrop Grumman (excluding ships) and Raytheon have gone up since 2009 and remained flat at Boeing’s defense unit. “We expect to see generally stable operating margins over the next few years,” the report says.