America may be broke and that could spell bad news for the defense industry, but don't look for big firms to try to branch out into the commercial world, writes defense commentator Loren Thompson.
Even though some companies have proven successful in broadening their portfolios -- or remaining conglomerates and playing in both the defense and civilian worlds -- even Austerity America might not convince many of your brand-name defense firms to try it, Thompson writes. In the past, he has praised big companies such as GE and United Technologies, and he often cites General Dynamics' success since it has owned the luxury jet-maker Gulfstream.
But "Defense-industry aversion to commercial work is grounded in other concerns, some of which are more faith-based than analytical," he writes.
The first two are that "defense demand could come roaring back" and "there’s still room to expand margins." Then Thompson goes onto argue that there can be room to flex even within flat budgets -- and of course, there's all the potential for foreign military sales we keep hearing about:
Even the biggest defense contractors only claim five or six percent of the $400 billion in contracts the Pentagon awards each year, so it is reasonable for company executives to suspect they might grow military sales despite slackening demand. For instance, Lockheed Martin dominates the federal market for military satellites, tactical aircraft, naval electronics and information systems, but is looking to grow in combat vehicles, small warships and cyber security. ITT Exelis has grown its military electronics expertise into technical services. Raytheon will soon generate a third of its military sales from overseas customers. Boeing has recently booked multi-billion-dollar military sales in India and Saudi Arabia. So although Pentagon demand for military hardware may fall in the years ahead, companies have reason to believe they don’t need to go outside defense to find new revenue sources.Thompson then argues that companies accustomed to dealing with the feds may not be able to easily adapt to the normal procedures of the business world. He winds up by making the case that even though diversification could make sense for a defense contractor's survival, there are too many headwinds from the world of investors:
It’s been a long time since Wall Street favored conglomerates, and that’s what any defense company that got into commercial work in a big way would be. The trend recently has been in the opposite direction, as activist investors pressure conglomerates with defense holdings such as ITT and L3 to break up. Also, the trend in institutional investing and mutual funds has been to assign money managers to particular market segments, which means an aerospace/defense company that also makes commercial trucks doesn’t fit in anyone’s portfolio. Money managers will buy the idea of military contractors diversifying into “adjacencies” up to a point, but they prefer simple stories and value the “counter-cyclical” features of defense stocks (meaning the stocks don’t follow the rhythms of the commercial business cycle). They like the fact GD owns a high-end bizjet manufacturer now that military demand is softening, but it would be a different story if GD bought Urban Outfitters.Quite -- although there's probably a simpler reason besides investor pressure: With a earnings of just under $2 billion per year, all of Urban Outfitters would be worth less to GD than a single Virginia-class submarine. Until the prospects of the defense game got so bleak this type of equation was less lopsided, that could be the ultimate reason why defense firms are staying in their lane -- there's still a ton of money in it.