July 28, 2016
Dry Powder on Stormy Seas
Several large contractors’ quarterly results may indicate a state change in their treatment of investable cash.
By James Hasik
First, let’s recount the motivation: contractors have been madly repurchasing shares because their investment incentives have been lacking. How so? Last year, Doug Cameron of the Wall Street Journal attributed buyback enthusiasm at Northrop Grumman and General Dynamics in particular to “strong operating performance [and a] lack of deal targets.” With shooting wars underway and officialdom frowning on mergers, the cash-to-dealbook ratio grew, and eventually most prices climbed too high for sane CFOs to contemplate.
Another disincentive, however, has been structural. When the US government pays your development costs and buys your tooling for you, there’s only so much need for your own money. Thus, for decades American defense contractors have been running a close game on cash, and at times, even operating with negative working capital. That is, when the customer advances your cash in excess of your incurred costs, you don’t need to hold your own as a rainy day fund. Some of that cash has come from early progress payments from US customers, and some from deposits from foreign customers. Either way, it has been great business for contractors.
An early sign of change may be found in the Joint Strike Fighter program. As Max Baker of the Fort Worth Star Telegram observed, Lockheed generated $1.5 billion in cash from operations in the second quarter of this year. The problem was that the company unexpectedly needed to advance $900 million of its own money to suppliers to keep the F-35 line going. Price negotiations have been dragging on with the government’s program office regarding production of Lot 10, and Lockheed prefers to operate “at risk”. The company did still rack up $1 billion in accounting profits, but an almost-billion in working capital is real money to anyone below the federal level of thinking.
The other side of lowering working capital requirements is found down the supply chain. The US government might pay in advance, but its prime contractors generally don’t. In a conference call to discuss Rockwell Collins’ quarterly results, CEO Kelly Ortberg called Boeing “delinquent” in payments for deliveries of avionics. Boeing calls this adjusting payment terms to industry norms, as part of its Partnering for Success initiative. Suppliers often call it where’s my money. For its part, Boeing lost $234 million this quarter, and in its filing, actually floated the idea of soon ending production of the iconic 747. For now, at least, the squeeze may not let up.
In Europe, this is as much the same as it is different. Airbus did just announce quarterly profits of €1.18 billion ($1.31 billion). That figure, however, includes a charge of another €1 billion, atop €5 billion previously, for its development and production of the A400M Atlas. Airbus CEO Tom Enders has admitted that many of the "massive problems” with the airlifter are the company’s fault, though some—like the choice of turboprop—were politically induced. Either way, the A400M will end up a massive money-loser for Airbus. OCCAR, which manages the procurement for six European member states and a few other customers, actually thinks that a deal is a deal, and that cash flow and profits are the contractor’s problem.
Meanwhile, Facebook just announced a quarterly profit of $2 billion, almost all from advertising revenues and selling your personal data. Let that provide a little perspective on how the arms and aircraft business can be challenging. The business may also be changing, if technological and political conditions upend patterns of spending. Council member Byron Callan recently undertook some research on the question of how much [working capital] is enough. An exchange of ideas pointed to an inverted relationship between a contractor’s “dry powder” (its ratio of short-term to long-term assets) and its valuation in relation to its EV/EBITDA ratio. Specifically, Byron wrote that too much dry powder implies a “lack of creativity in finding attractive returns, and fear that something big and dumb may be in the wings.” Alternatively, too little may indicate that companies “may not have the flexibility to pursue new opportunities or to navigate stormier seas.”
At least one contractor has already rethought its strategy, and along these lines. As James Bach of the Washington Business Journal recently wrote, Northrop Grumman has started “pivoting from share repurchases to R&D” spending. CEO Wes Bush announced this initiative at the Bernstein Thirty-Second Annual Strategic Decisions Conference in June, for as Marjorie Censer of Inside Defense wrote, management believe that they “have a responsibility to help the United States assure its technological superiority.” That’s inspiring, but the shareholders will want some inspiration too.
So will this work? Defense officials have indeed been exhorting industry to invest its own money, and for some time. On occasion, that works out well—as Raytheon found from pouring its own money into its Air and Missile Defense Radar (AMDR) design. At least as often, the lack of a homegrown requirement within the US military services precludes programmatic success—as Northrop still remembers from its F-20 Tigershark project. More often than not, those investments must still contend with negotiating policies and even statutes limiting contractors’ financial success, regardless of what money they’ve invested on their own. Large contractors may start hoarding a little cash, but what they do with it depends on the profitability of both their current and future projects. Large customers should know how they can constructively influence that decision-making.
James Hasik is a senior fellow at the Brent Scowcroft Center on International Security.