Defense contractors are repurchasing shares because investment incentives are lacking.

About a month ago (14 August 2015), Politico Pro highlighted how the largest US defense contractors are running their businesses substantially for cash, passing as much of their earnings as they can to shareholders as dividends and share repurchases. “Top Pentagon officials,” the reporter went on, “have complained that the companies, which unlike many other corporations get the lion’s share of their funding from taxpayers, should be using their cash to increase their investments in research and development on new technologies that could help the military in the future.” Democratic presidential candidates Hillary Clinton and (predictably) Bernie Sanders have been complaining in this way about business generally. So has even HASC ranking member Congressman Adam Smith. That might not seem very Adam-Smith of him, but the narrower point about defense contractors may be well-taken. The issue is how to fix their incentives.

Ten days after that story (24 August), James Surowiecki of the New Yorker thoroughly trashed that viewpoint with his essay “The Short-Termism Myth.” For every time I hear a screed like those from Clinton and Sanders, I remember Larry the Liquidator’s (Danny Devito’s) speech from Other People’s Money (Warner Brothers, 1991). On my first day of class in graduate corporate finance, Luigi Zingales showed us that scene to explain why surviving is actually not the long-term goal. Towards the end, Devito is telling the shareholders why they should sell out:

Take the money. Invest it somewhere else. Maybe, maybe you’ll get lucky and it’ll be used productively. And if it is, you’ll create new jobs and provide a service for the economy and, God forbid, even make a few bucks for yourselves. And if anybody asks, tell ’em ya gave at the plant.

Much has been made lately of how IBM recently “reported its thirteenth straight decline in quarterly revenue” (Fortune, 10 August), and yet continues to return cash to shareholders. Should the company be rebuilding? If so, why is Berkshire Hathaway investing? When I briefly worked for IBM fifteen years ago, we used to wince about the huge gap between those slick letterbox commercials about leading edge technology and what we could actually provide clients. It was actually quite embarrassing when they’d ask. We generated lots of patents, but far less practical innovation. IBM today is hardly pumping sand from the ideas well, but even if it were, then Omaha and everyone else could happily take those huge dividends, and put them into other businesses with better futures. In the long run, IBM would be a smaller company, and maybe one centered on a fewer but better business ideas.

Thus was I recently arguing about HP and the old EDS—if you can’t compete in the Cloud, then maybe you shouldn’t try to compete with the Cloud. So I get annoyed when I hear politicians playing to the crowd, decrying dividends and share buybacks, whatever a company’s business prospects. Clinton and Smith at least should know better. Harvesting the cash actually can provide investment in the future—just according to the shareholders’ wishes, and not the specific diktat of any single management team.

All that said, I agree that there is a systemic problem when most of the large American military contractors are declining to reinvest.

To begin with, they do have the money. As Byron Callan of Capital Alpha wrote recently, margins for big American contractors may be unimpressive in comparison to those of information technology firms, but they are pretty healthy in comparison to industrial or engineering services firms. The problem lies with the incentives that their customers have systematically, if unconsciously, created over time.

Most defense ministries are very comfortable buying the same sort of kit along the same technological trajectories from the same suppliers for decades.  Many of those buyer-supplier relationships, as CAPE Director Jamie Morin noted at the Atlantic Council last week, are double monopolies—in which the government is the only buyer and the contractor in question the only reasonable source. So to ensure its interests in the absence of market discipline, government spends a lot of managerial attention on the governance of those relationships, and extends its presence into an otherwise commercial realm. In the United States and the UK and a few other places, the government is very happy to supply the bulk of the R&D(&T&E) funding itself. In the United States, in some cases, the government will even supply the factory floor space.

All of this is great for returns on invested capital. Thus none of these firms need to choose IBM’s apparent path. But with those long-standing buying patterns, defense ministries—and particularly the US Defense Department—create a double-sided disincentive to innovation off the beaten path. Established suppliers needn’t spend their own money, but then only bring the military the ideas the military has already decided it “requires.” Potential entrants perhaps shouldn’t spend their own money, as the success of a SpaceX seems a blue moon occurrence—even for something that the military has needed for decades.

To get around this problem, could defense ministries have one set of rules for established firms and another for startups? In the United States, there are some small business exemptions, but these clearly don’t apply to SpaceX or Uber or Amazon or anyone else at such scale. Frankly, one should question the sensibility and even legitimacy of different public procurement laws for different types of companies. In contrast, though, defense ministries can formulate different supplier relationship management policies.

One of those realms of policy is profitability, which creates much of the incentive to reinvest. There’s little reason to pay Huntington Ingalls a 20 percent margin on its seemingly endless franchise of building nuclear submarines to print—and the Navy doesn’t. But there’s also a fight underway within the Defense Department about whether Boeing should make 13 percent manufacturing JDAMs, or nothing above 11 percent, as the more strident faction insists. The company has no moral right to a sinecure, but the prospect of a long-term franchise with 13 percent will, ceteris paribus, attract more bidders—and maybe more good ideas—for the next new thing than one with 11 percent.

Fairly, this is not purely an Evil Big Government problem. Procurement people at Toyota and Siemens and General Electric turn the screws on their best suppliers years-on-end when they think that they have buyer power. The suppliers still mostly keep coming back, because the opportunities are huge. But recall General Motors’ plight. In the 1990s, several big automotive parts suppliers stopped bringing their best technology to GM, simply because they couldn’t make the margins to merit the investment. A lack of innovation was not the only cause, but we all also know how that story ended—and better that the military-industrial complex writ large today resemble IBM than GM!

In formulating better policy about profits at different suppliers, bureaucratic discretion is essential. Conjuring up a negotiating position on margins requires foresight about technological possibilities, and those aren’t too analytically tractable. To get this right, the acquisition policy directorate at the Pentagon would need to rewrite part of the Defense Federal Acquisition Regulations Supplement, specifically DFARS 215.404–73. That’s the section on alternate structured contract approaches to calculating profit policy.

On the face of it, program managers already can get the authority they need to raise targeted margins beyond the weighted guidelines. According to DFARS 215.404–4(c)(2)(c), contracting officers “may use an alternative structured approach when… the weighed guidelines method does not produce a reasonable profit objective and the head of the contracting activity approves use of that alternative approach in writing.” Thus, the DFARS already provides the workaround; the boss just needs to sign off. The alternate approach mandates the same categories as the standard structured approach, but does not require filling out blocks 21 through 30 of DD Form 1547 (“Record of Weighted Guidines Application”). That’s good, because those sections steer the program manager towards just fudging the prescriptive numbers in the standard approach, which are way too low to interest most commercial IT firms.

However, with the sort of culture that has persisted for decades in the Defense Department, the recent and ongoing examples of screw-turning from the pricing policy directorate, and the sometimes uninspired teaching of industrial economics in the training programs, I fear that too few program managers will ever come around to thinking outside the boxes of the DD 1547. Making up one’s own rules is explicitly allowed. The trouble is that enterprising program managers can be perceived not just as thinking outside the box, but coloring outside the lines.

James Hasik is a senior fellow at the Scowcroft Center for Strategy and Security.

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