Analysis: Defence contractors face new cost climate

1043

Unprecedented interest from Asia and the Middle East was good news for US defence contractors at this year’s Farnborough Airshow, but the industry’s biggest players remain under mounting pressure to revamp their portfolios and boost earnings.

Defence budgets are flat or declining in the United States and Europe, making it vital for companies to find revenues overseas, cut production and overhead costs, and bring their businesses more in line with nimble commercial development practices.

Research and development spending is also down, there are fewer program starts than ever, and defence departments around the world are less and less dependent on the flashy warplanes and military hardware that helped create today’s giant defence companies as the focus shifts to cyber security and unmanned planes, Reuters reports.
“The other shoe is dropping finally now,” said Tom Captain, global aerospace and defence sector leader for Deloitte LLP.

Captain says Wall Street is demanding continued growth, prompting nearly every major defence company to adjust its portfolio by selling off unprofitable units and acquiring companies with critical technologies.
“Stock markets are not going to be kind to companies whose margins and revenues are not growing,” Captain said.

Northrop Grumman Corp recently said it would sell or spin off its lackluster shipbuilding unit, Lockheed Martin Corp announced plans to divest two units and offered buyouts to senior managers to pare down its executive payrolls, and Boeing Co restructured its defence unit last year.

Affordability and cost-cutting were common themes at the biennial air show, the world’s largest, with all major players eager to fall in line with a major Pentagon drive to cut more than $100 billion from overhead costs in coming years.

Given stagnant revenues in their home markets, industry executives say they are looking for new orders overseas as well as acquisitions to help augment their core strengths and bolster operations in adjacent markets.

NEW CLIMATE CREATES OPPORTUNITIES FOR SMALLER FIRMS

Growing frustration about cost overruns and delays in traditional programs have also opened up opportunities for companies willing to shell out their own money to develop innovative new weapons that can be acquired by troops more quickly.

That has given an unusual edge to smaller, more agile companies outside the small circle of traditional defence contractors — firms that in turn become attractive takeover targets for their bigger, less flexible counterparts.

U.S. defence officials have clearly backed away from use of lead system integrators like Boeing on contracts like the Future Combat Systems Army modernization, and have signalled that they are happy to award contracts to companies outside the former inner circle.

Britain’s BAE Systems Plc recently scaled back its ground vehicles business after losing a $3 billion contract to build medium-sized U.S. Army trucks. Oshkosh Corp underbid the 17-year incumbent by over 20 percent.

Bucking naysayers, General Atomics used its own money to develop the unmanned Predator plane before showing it to Pentagon officials. Now, Predator is one of the most heavily used assets in Iraq and Afghanistan.

General Atomics, which is privately held, has already sold 435 Predator-series planes, and is poised to sell dozens more to countries in the Middle East and Asia.
“We’re an example of how the system should work,” said Christopher Ames, a retired Navy admiral and head of business development for the San Diego-based company, adding that his firm is more flexible to respond to changing needs than bigger companies that have to report to shareholders every quarter.

David Melcher, president of the defence unit of ITT Corp, told Reuters that his company is exploring different ways to help the Pentagon save money in the current climate.

For instance, the company spent tens of millions of dollars to develop an add-on capability called “Sidehat” to expand the capability of over 500,000 military radios at half the price of a complex radio program that is years behind schedule.

It also pared back management last January by cutting seven divisions down to three, and it continues to pump its own research funds into programs while seeking out commercially available technologies to repackage for military use, Melcher said.
“We are leaning forward and trying to walk the walk,” he said. “I won’t say that the defence industry was fat, but there were some redundancies in capability.”

Frederick Strader, head of Textron Inc’s defence unit, told Reuters his company aims to offer the Pentagon “affordable innovation that works,” with a focus on making upgrades to existing systems rather than on the purchase of new ones.



Asked whether the industry had gotten bloated during the years of booming defence budgets, he said: “That’s what happens in any industry over time. Things move to the complicated side.”