CEOs Not Yet Ready to Take a Gamble

Where’s the payoff?

That’s the question for which defense executives don’t have clear answers as they weigh investment choices in an uncertain market.

In years past, these decisions would have been relatively straightforward and shaped almost entirely by the Pentagon’s five-year research, development and procurement funding plan.

The game has changed dramatically during the Obama presidency as partisan fights derailed the customary budget process and the federal government almost every year has been saved from the brink of shutdown by 11th hour deals.

In this climate, top defense contractors have opted to deploy their cash, repurchasing their stocks and paying out dividends to shareholders. So it comes as no surprise that private investments in new technology by the top firms in the aerospace and defense industry have been on a downward slope, despite the constant pressure for innovation and growth.

New data on the defense and aerospace sector from the consulting firm Deloitte shows that company-funded IRAD, shorthand for independent research and development, has declined from 4.27 percent of revenues in 2009 to 3.14 percent in 2014, a 26.5 percent drop.

The Pentagon has taken a dim view of this trend. The Defense Department’s top weapons buyer Frank Kendall has called out defense CEOs for hoarding cash instead of pouring more money into next-generation technology. This is a burning concern for officials like Kendall who worry about keeping the military technologically sharp. It’s not just IRAD that is coming down. Federal funding for defense research, development, testing and evaluation dipped from $79.7 billion in 2009 to $62.9 billion in 2014, a 21.08 percent decline. The Defense Department projects a further contraction of 10 percent in RDT&E funding between 2016 and 2020.

“The iconic technological innovations that characterize the sector’s history have been largely dependent on funding from the U.S. government, as well as internal company sources,” says Deloitte. The upshot is a likely erosion in competitiveness for defense and aerospace, analysts warn, at a time of heightened global tensions, aggressive military actions by America’s adversaries and increased competition in commercial markets.

The Pentagon understandably wants contractors to give less money to shareholders and to help foot the bill for new product development. But that might be an unreasonable expectation, especially in today’s climate, say Bloomberg Government analysts Robert Levinson and Jesse Holler. “While the big five defense contractors are giving a lot more money back to shareholders than they’re investing in R&D, additional investments may not be justified by financial returns,” they point out. “With defense spending levels locked in through fiscal 2017, investment choices probably won’t change much for contractors in the near future. R&D investments may not increase at all, unless defense technologies can be leveraged into broader, possibly commercial markets.”

One industry player that is bucking the trend is Textron AirLand. The company a year and a half ago unveiled a commercially developed military airplane that is being watched as a bellwether. If Textron’s gamble pays off, it might encourage other companies to take more risk. If it doesn’t, the industry and its investors will see it as a cautionary tale.

Textron’s surveillance and strike jet, the Scorpion, was developed with private funding in 23 months. There are still no signs that the Pentagon will buy it, but the company is optimistic about the international market. “We made a decision to make an investment in a commercially developed military airplane,” Textron AirLand President Bill Anderson says in an interview. This past summer, he spent seven weeks in eight countries marketing the airplane.

The Pentagon asked industry to invest, and this is one company’s answer to that call. “We did something completely different and completely outside the system,” Anderson says. The reaction from the Defense Department has been limited so far. “The Air Force and Navy are taking a hard look at the value and capability,” he says. “They are actively discussing how they could use it.”

The Defense Department is accustomed to buying highly customized equipment made to stringent specs, so it remains to be seen whether it is serious about off-the-shelf procurements. “Change for big institutions takes a long time,” says Anderson.

So how much patience will Textron’s shareholders have? “We are actively pursuing sales globally,” he adds. “We are not waiting for the DoD to respond. At this point, international sales look like they would move much faster than DoD.”

There is not much appetite for big technology bets among defense contractors. For the time being, returning money to shareholders through stock buybacks and dividends seems to be the safest path. “It’s easy to see why Kendall decries stock buybacks,” Bloomberg analysts say. In 2014 the top five defense contractors — Lockheed Martin, Boeing, Raytheon, General Dynamics and Northrop Grumman — collectively distributed dividends and bought back stock valued at $18.6 billion, about 88 percent of their cash from operating activities that year. The same year, those five companies invested $5.2 billion in R&D.

Defense contractors are no different than other major corporations in America’s civilian economy when it comes to IRAD, Bloomberg notes. “When R&D spending by the top five defense contractors is compared with that of the top five companies in the Standard & Poor’s 500 Index, they have similar percentages.”

The problem for defense firms is that they don’t see an incentive to invest. There are fewer programs to bid for. Once a product is developed, even if it’s successful, production runs are small. There is also pressure on government procurement officers to squeeze contractors’ profit margins.

“Commercial companies invest heavily because there is a potential to reap huge profits at levels the government may find unpalatable,” the Bloomberg analysis concludes. “When no clear future payoff exists, contractors may be deterred from making further investments in R&D. Until the model changes, government may need to pay for R&D above and beyond what the market will bear.”

Topics: Business Trends, Defense Department, Procurement, Defense Department, Science and Engineering Technology