Weapons makers reported surprisingly strong profit margins this week, even as budget cuts are starting to weigh on revenues. That has prompted a big question: how long can the defense industry sustain good margins?
The sector is clearly facing leaner times, with $487 billion in spending reductions slated for the next decade and another $500 billion in cuts due to kick in next year under the process known as sequestration.
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But experts expect a year or more to elapse before those changes ripple through to corporate income statements.
Industry executives told analysts this week that solid order backlogs and continued cost-cutting would protect their overall margins, although some parts of the defense business are already showing signs of strain as the United States winds down military spending after more than a decade of growth.
"We're pushing ourselves," Lockheed Martin Corp Chief Executive Bob Stevens said, underscoring the company's focus on cutting costs and making its weapons less expensive. "With or without sequestration, we know that we're facing a long cycle where the demands of our security customers are going to go up ... and they're not going to have the economic resources available to meet those growing demands."
The durability of defense profit margins could have a big effect not just on stock prices, but on investment and employment as well. Defense company shares have rebounded this year, with bellwether General Dynamics up nearly 16 percent, compared with a 3 percent gain for the S&P 500 index .
At the same time, the defense industry could shed as many as 88,000 jobs this year, double the 44,000 cut in 2010. The cuts could quadruple from 2010 levels if sequestration is not averted, according to Tom Captain, leader of aerospace and defense analysis at Deloitte.
Analysts say shorter-cycle businesses such as services - where margins are historically lower to begin with - already are feeling the heat. But it may take time until margins in longer-cycle businesses like shipbuilding and other metal-bending manufacturing operations come under significant pressure.
"You're seeing it in isolated areas already ... but it could take a while for the downward pressures to finally be seen on an aggregate basis," said Rob Stallard with RBC Capital Markets, adding that point might be reached in another year or so. "It does take a very long time to flow through the industry."
He said the big arms makers were "a bit fat and happy" after 15 years of growing budgets, and could probably expand the cost-cutting efforts they had already begun, which would allow them to maintain good profit margins despite pressure on revenues.
"They have not seen lean by comparison to what goes on in the commercial world," Stallard said. "There's definitely more that could be done there."
Lockheed, Boeing Co's defense division, Northrop Grumman Corp and Raytheon Co this week beat analyst forecasts with higher earnings and solid margins despite weakening sales.
General Dynamics missed forecasts due to a one-time charge, although maintained its guidance for full-year earnings at roughly the same level, assuaging investors' concerns.
The big companies, eager to shore up investor support, say they remain focused on consolidating facilities, cutting jobs and improving productivity to maintain margins. They also highlight the big backlogs they have.
Margins reported by the top five defense companies ranged from 10.5 percent in Boeing's defense business to 13 percent at Raytheon, for an average around 11.5 percent.
Those margins are higher than they were in the 1990s, but still far below margins seen in the commercial world, where technology companies shoulder research and development costs on their own instead of relying on government funding, and must recoup those costs.
Another plus: Most big defense companies are aggressively pursuing international orders, which generally have higher profit margins, said Jason Gursky, an analyst at Citi Research.
Many companies also have weapons programs that are transitioning from development to production, which generally results in more predictable outlays and better returns, he said.
"It's not that they're outperforming per se, but they're moving into higher-margin activities and that trend is likely to continue for a while," Gursky said.
The third-quarter reports did show increasing and worse-than-expected pressure on sectors of the defense business that are focused on providing services rather than products.
Classic service providers such as CACI Inc , Mantech International Corp , and Science Applications International Corp are the hardest hit so far, but even the service divisions of Lockheed, Northrop and other big firms reported lower margins, Stallard said.
General Dynamics Chief Executive Jay Johnson told analysts it was "a blinding flash of the obvious" that his company was seeing the most impact on margins in its information systems sector, where services account for about half of revenues.
"There's a margin reality that's attached to that," Johnson said. He said that sector has just won some significant contract awards that would help improve margins, but program managers are insisting on more competition, scaling back contracts, and awarding contracts by assessing the "lowest price, technically acceptable" bid, rather than "best value."
Defense consultant Loren Thompson of the Lexington Institute said the companies had been preparing for the downturn for years, taking aggressive cost-cutting measures like closing plants and laying off workers to preserve profits, while maintaining solid dividends and buying back shares.
Eventually, Thompson said, cost-cutting efforts will reach a limit since it will get harder and harder for companies to find efficiencies on a dwindling number of programs.
"There's a fine line between cutting unnecessary costs and beginning to undermine future business prospects," he said, noting that scaling back research and development spending or marketing would eventually eat into a company's ability to respond to rapidly changing military requirements.
(Reporting by Andrea Shalal-Esa; Editing by Alwyn Scott and Richard Chang)