In the cyclical ebb and flow of the defense market, finding an inflection point — the moment when boom turns into downturn — can be difficult. This time, it's obvious.
Only two of the top dozen companies on this year's Defense News Top 100 list saw defense revenue growth, with combined defense revenue for the Top 100 companies dropping by about 1 percent to $414.3 billion, down from $418.8 billion in 2010. In the previous year's list, total revenue grew by more than 4 percent.
The revenue number was buoyed by nine new companies joining the list, and a weak dollar that gave non-U.S. companies an average boost of nearly 4 percent in exchange rates compared to 2010.
The drop in revenue is just the beginning of what's projected to be a steep reduction in U.S. defense spending in coming years, as 2011 numbers predate the $487 billion in cuts over 10 years mandated by the Budget Control Act, as well as the nearly $500 billion in automatic budget cuts that could take effect Jan. 2.
The top of the list saw some reshuffling, as Boeing (No. 2) jumped two spots, hurdling both BAE Systems (No. 3) and Northrop Grumman (No. 6). Two spinoffs, Huntington Ingalls (No. 13) and ITT Exelis (No. 21), joined the list, and were two of only three companies to appear in the top 25 for the first time.
Northrop's decline of nearly $10 billion is partially accounted for by the $6.6 billion that Huntington Ingalls, which it divested in 2010, earned.
“The decline has actually begun; it clearly shows in the figures,” said Phil Finnegan, director of corporate analysis at the Teal Group, Fairfax, Va. “It again highlights the dominance of the U.S. as a market. The U.S. is by far the biggest market, it's beginning to decline, and so the largest companies are beginning to decline.”
Of the two companies to see increases in the top 14, only Lockheed Martin (No. 1) saw growth in local currency revenue. Italian group Finmeccanica's (No. 8)
1 percent increase in U.S. dollar revenue masked a nearly 4 percent reduction in overall revenue, offset by a 5 percent spike in the value of the euro.
Overall, the dollar softened as the average exchange rate for foreign currencies used on the list experienced a lull in 2010, and rose by nearly 4 percent in 2011, helping to lessen the blow of revenue declines.
MBDA, the European missiles house owned by BAE, Finmeccanica and EADS (No. 7), with revenue of $3.98 billion would have been No. 22 if listed as a separate company.
While European companies faced difficult fiscal environments locally, Japanese companies, led by Kawasaki Heavy Industries (No. 41), saw growth on the back of ramped-up programs, including the new P-1 maritime patrol aircraft, and a strong yen.
And some Russian companies, including Sukhoi and RSK MiG, boosted revenue with exports to Africa and Asia, including Uganda, Vietnam and India.
The list saw some of its steepest declines among companies with interests in ground systems, particularly the U.S. mine-resistant, ambush protected-heavy vehicle program, as BAE fell two spots, Oshkosh (No. 18) fell five, and Navistar (No. 48) fell eight.
The drawdown of the U.S.' military presence in Iraq was cited by experts as being a catalyst for reduction.
Early U.S. Spending Cuts
That U.S. defense spending declined in 2011 was not immediately apparent in overall Defense Department spending figures, as outlays rose by 1.6 percent from 2010. Both personnel and operations and maintenance spending rose. But in the accounts that matter most to defense contractors, procurement outlays fell 4.2 percent, and research and development outlays fell 2.8 percent.
“If you look back during the tenure of Secretary of Defense Bob Gates, he made a number of program and portfolio decisions, some of which affect our company,” said Bob Stevens, chief executive of Lockheed Martin.
“We've seen progressive actions taken, either to realign program portfolios or to focus on deficit reduction or to participate under all of the deficit control initiatives, that lead us to conclude that there would be an overall decline in defense spending,” he said. “We've been preparing for it.”
In particular, the lack of big-ticket items has had an effect, said Jay Hennig, president of Moog's (No. 75) space and defense group.
“There are no big programs that were in the development phase,” Hennig said, pointing out that the U.S. Army's Future Combat Systems program was canceled, while the F-35 Joint Strike Fighter “is in production. The Joint Common Missile, that funding has been severely whacked. Where does the development money go? It's just not there.”
Confronted with the decline in the U.S., Hennig's company is looking overseas.
“I would say our proposals outside of the U.S. are now 50 percent of our proposals,” he said. “Two years before, it was 10 percent. It's a huge change.”
Stevens said Lockheed is aiming to increase its percentage of non-U.S. revenue from roughly 17 percent to more than 20 percent in the next 10 years.
But growth in non-U.S. defense spending cannot counter the DoD reductions, Finnegan said.
“There's no backstop in the world,” he said. “European budgets are declining, or even under more pressure than U.S. budgets, and the places where companies are looking for growth, namely Asia, Brazil, and to a lesser extent the Middle East, those simply cannot make up for the decline of the large budgets in the developed countries.”
Global military spending remained flat in 2011, increasing by only 0.3 percent, according to a recent report from the Stockholm International Peace Research Institute. That number includes double-digit Chinese military growth, spending which rarely involves outside companies.
“The pressure for European companies to do work overseas is even greater because of the decline in the domestic markets,” he said. “You can be sure that they're going to be very aggressive in terms of pricing and in terms of technology transfer. That's going to become an issue as they try to limit the impact of the decline in the U.S. budget by going overseas.”
Companies Going Commercial
With few growth opportunities in the broader defense markets, companies are turning to commercial endeavors. While defense revenue decreased, total revenue among Top 100 companies increased.
In the previous year's Top 100 list, 32.8 percent of the total revenue reported by companies on the list came from defense. This year, that number dropped to 30.8 percent.
Investors have been critical of commercial ventures by defense companies, but thus far, companies have been acting prudently, said Byron Callan, an analyst with Capital Alpha Partners.
“No one's done anything equivalent to what Lockheed did in the late '90s, when they set up a global telecommunications business,” he said. “These adjacencies seem fine. Investors should be fine with that.”
Lockheed is looking at expanding its commercial business during this down cycle, as well, but carefully, Stevens said.
“We understand where our strengths are, what our core markets are,” he said. “We understand how to take those mature products and services into the international markets. We have interest in adjacent markets that include cybersecurity, energy, health care and so on.”
The bigger question may be whether some of the companies that have substantial commercial interests will stay in the market, Callan said.
“Companies like Rockwell Collins (No. 34), Textron (No. 19), they already have pretty good commercial businesses,” he said. “The question for them is, why are you sticking around in the defense business, other than you think you're going to weather the storm better than anybody else?”
The 2011 declines are likely to be followed by further declines in 2012, experts said. But the deep cutting in the U.S. won't hit until fiscal 2013, when the caps on defense spending, included in the Budget Control Act, shave roughly $50 billion per year off the projected U.S. defense budget.
The drawdown of coalition forces in Afghanistan also will likely result in cuts to spending, as well as the continued fiscal woes in Europe.
But most ominous are the automatic budget cuts, called sequestration, that could take effect on Jan. 2, totaling roughly $500 billion more in reductions.
“While our company some time ago embraced an overhead reduction, cost reduction affordability program, to align with the Budget Control Act reductions of $487 billion over 10 years, we don't have a plan in place today to meet the demands of sequestration set to take place on Jan. 2,” Stevens said. “I believe there's no one in the industry that has a refined plan to do that, because the exact implementation of sequestration is not at all clear.
“With the prospect of sequestration, I think we'll see huge disruption in the industry,” Stevens said. “We won't be talking about a couple of percent declines in revenue. We'll be talking about disruptions in the labor force, significant disruptions in the ongoing continuity of programs, an environment where there will likely be many requests for equitable adjustment as contracts are modified.”
Some of those last-minute preparations for the sequester might hit in late 2012, because of U.S. labor laws that require companies to provide 60 to 90 days of notice before layoffs, Hennig said. “You may think you've got until Jan. 1, but we don't. ... The defense industry will be severely affected.”
The result may be that the 2013 Top 100 list looks very different.
“I don't know how many companies will be on this list the next year,” Callan said. “I think we'll shake a few trees here.”