Fallout from Lockheed Martin's loss of a second Littoral Combat Ship comes after the company was spotlighted for problems with the VH-71 presidential replacement helicopter fleet and has raised some analysts' attention over the U.S. Navy's recent disfavor for lead systems integrators.

But the potential for fixed-price (FP) development contracts has Wall Street even more on edge.

"There is the risk that the cancellation could upset the Navy and perhaps have broader repercussions," Merrill Lynch analyst Ronald Epstein told clients April 13. "We believe the termination points to a potential weakness in the system integrator model and suggests that domain expertise is of vital importance."

Morgan Stanley analysts Heidi Wood, Greg Alexopoulos and Lee Rawlings said the Navy's cancellation of LCS 3 - Lockheed's second LCS after LCS 1 in an LCS program it was splitting with General Dynamics - points to several "important structural changes" since former Defense Secretary Donald Rumsfeld left the Pentagon after the November elections.

"Military transformation appears to have lost some important political backing," they said in a lengthy client note over the late April 12 cancellation. "Congress appears less tolerant of industry base glitches and there appears to be two areas where debate is centering: 1) the viability of the lead systems integrator approach, and 2) stronger interest in moving to fixed-price incentive contracts where possible."

The Wall Street analysts also said the LCS 3 cancellation for Lockheed will not significantly impact the massive defense contractor's bottom line, but they see the unusual Navy move as a telltale sign of a tightening fiscal environment (DAILY, April 16).

Lockheed "is clearly on notice with the Navy and there are oblique concerns as to whether the Navy has full confidence in [Lockheed's] ability to execute as a shipbuilding prime," the Morgan Stanley analysts said. "Certainly, the swiftness of the Navy decision to outright cancel [the] #3 boat and unwillingness to work more cooperatively with [Lockheed] sends a message we're not sure we have command of the whole meaning."

Wall Street, the Morgan Stanley analysts included, remains "alarmed" over the specter of FP development contracts - but that is not the same as production contracts that seem increasingly headed toward different FP incentive structures, they noted.

"It's important not to blow FP too out of proportion," they said. Only a small percentage of programs are available for re-contracting, and many programs are already FP and are fine. So far, Wall Street has not seen much advocacy yet for FP development contracting beyond the Navy, and even there, the Morgan Stanley analysts highlighted the fact that LCS 1 was not pressed into FP development.