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Top 100: Looking Beyond Defense

Firms Grow Revenue - By Diversifying

Jul. 21, 2013 - 03:45AM   |  
Tower defenders protect Bagram
A US airman scans the perimeter around his guard tower at Bagram Air Field, Afghanistan. Defense companies, facing spending cuts, are successfully branching out into new business areas. (US Air Force)
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WASHINGTON — The decline in defense spending by a block of nations in Europe and the US hasn’t been catastrophic, but it’s making its presence felt on this year’s Defense News Top 100 list.

The sum of defense revenue from this year’s batch of companies is down more than US $13 billion compared with last year, a 3 percent decline that doesn’t factor in the additional cost of inflation. The 2013 list marks the second consecutive decline, with a 1 percent reduction for 2011 revenues compared with 2010.

That’s not a surprise to most analysts, as the US Defense Department picked up the pace of its cost cutting in 2012, and several European countries facing their own economic pressures did the same. But while defense revenue numbers weren’t good, total revenue remained strong, increasing by 3 percent.

Those diverging numbers are driving a new reality for defense companies: They are focusing less on defense. Five years ago, 38 percent of total revenue listed by the top 100 companies was derived from defense. For 2012, that number is just 28 percent, a tremendous drop and sign of how the industry is pushing to diversify.

Once again, Lockheed Martin tops the list, and once again, despite overall decline, the company posted gains. Raytheon (No. 4) jumped a spot, marking one of only two changes in the top 10, along with United Technologies climbing to No. 9.

Seven of the top 10 posted declining defense revenue. The overall list saw a 3 percent decline in the sum of defense revenue compared with last year. However, if all of the companies on this year’s list had been on last year’s list, the drop would have been only 2 percent.

While a wide range of regions were hit by the defense recession, one country’s companies reported staggering increases: Russia. Almaz-Antey (No. 14) climbed 11 spots, becoming a top five European defense company on the back of a 62 percent increase in defense revenue. Russian Helicopters (No. 24) saw a 32 percent spike, United Engine-Building (No. 49) a 49 percent increase, and RTI (No. 80) an 12 percent rise in defense revenue.

Not every Russian company saw increases: Sukhoi (No. 43), Irkut (No. 62) and MiG (No. 93) were all down. But the enormous growth of several Russian companies had a staggering impact on the overall numbers for the list.

The non-Russian companies on the list reported a decline of more than 3 percent in defense revenue, meaning that the Russian companies in general, and the four companies that grew in particular, as a group managed to improve the overall results of the list by 1 percent.

Non-US companies on the list were down 5 percent if Russian companies are excluded, and close to 2 percent if the Russian companies are included. The declining figures for many European companies were reinforced by an improved dollar in 2012 vs. 2011. MBDA, the European missile-maker owned by BAE, Finmeccanica and EADS, with revenue of $3.86 billion, would have been No. 23 if listed as a separate company.

The growth in the Russian companies can largely be attributed to tremendous increases in arms exports, which reached a record $14 billion in 2012, up 6 percent from 2011. Russia — the second largest arms exporter after the US — has more than doubled its exports since 2005.

That increase has coincided with a greater push by the Russian government to sell arms overseas, including the return of Russian aircraft to the 2013 Paris Air Show. Russia has been helped by India and China, two of Russia’s largest defense customers, rapidly boosting their military spending.

Russia has also been ratcheting up its own spending with plans to purchase $641 billion in military hardware from 2011 to 2020 to help stimulate growth in the sector in what would be one of the most significant build-ups since the Cold War.

US companies were down just under 2 percent on the year. Since the list is based on 2012 numbers, all of the earnings figures predate the implementation of the sequester. However, US defense spending projections had already been cut by nearly a half billion dollars before sequester kicked in. And since US defense spending still accounts for roughly half of the global total, any change in US policy has enormous impact on defense companies worldwide.

The current decline paired with the prospects of further cuts is of concern, said Frank Kendall, US defense undersecretary for acquisition, technology and logistics, in an interview with Defense News.

“I’m very concerned about it,” he said. “The largest companies will weather this; they have access to capital; they have big backlogs; they’re in pretty good shape from a cash position. This is cyclical; this isn’t going to last forever. The smaller companies are going to have much bigger problems. I’m very worried about our small businesses.”

Figuring out how far defense will fall will be exceedingly difficult because of the lack of fiscal clarity, said David Berteau, director of the International Security Program at the Center for Strategic and International Studies.

“We haven’t yet reached the floor of defense spending, both because of the statute Budget Control Act cuts and because we don’t have that overall budget deal that will let us know what that floor is,” he said.

Despite the cuts that have already happened, many defense companies have posted reasonably good profits. US defense stocks have grown tremendously in the past year based on solid earnings reports. But those earnings have been the result of cost-cutting moves that have outpaced government spending reductions. And those are moves that likely can’t continue, Berteau said.

“I don’t think that trend can continue for two reasons,” he said. “One is that many of the steps that the companies can take, they’ve already taken. You don’t get to reap those benefits over and over. You really only get them once. What you’re not seeing is that the companies are, by and large, eating into their backlog, and while current margins are good, backlog is way down. That has a big impact on future revenue and perhaps future margins.”

For Lockheed, which bucked the overall trend and grew its defense revenue by 2 percent, the full consequences of both the prior cuts and the sequester have not appeared.

“We are not seeing a significant impact yet, the year is not over, but it has been fairly minimal impact,” said Marillyn Hewson, Lockheed’s CEO. “We have had some contracts that have been impacted; we have a couple hundred people that are going to be on furlough. So we have had some impact, but not at what we expect.”

Hewson attributed the better-than-average performance to a “broad portfolio.”

“We have this broad, robust portfolio that is really well aligned, I believe, with customers’ priorities, and so with that, what we have to do is continue to stay abreast of their emerging needs and continue to strategically invest in technology and capabilities so that we can keep that portfolio well aligned with what they need,” she said.

But just as Russia has seen its exports blossom, defense companies worldwide will need to increase exports to stabilize defense revenues.

While most companies are planning international expansion, it’s not that simple, said Bill Sundermeier, president of the government systems division at FLIR (No. 88), during an interview last month.

“It’s a serious commitment to start doing this; you don’t just jump in and start taking orders and wait until the US business gets better a few years later,” he said. “It doesn’t work that way.”

FLIR fits many of the overall trends on the list. It’s rank was unchanged from last year, but its defense revenue was down. At the same time, it’s increasing its commercial business and, as a result, becoming less dependent on defense. In 2011, defense accounted for 46.1 percent of the company’s revenue; in 2012, that number was down to 44.1 percent.

“Our commercial business is fantastic and continuing to grow very nicely, and we’re focused on that part growing rapidly in the next few years,” he said.

Whether commercial and international business can make up for defense cuts in Europe and the US is unknown.

Berteau said companies have to try, given the limitations on defense spending.

“I’m not going to agree that they’ll make it all up, but I’m not going to say that they won’t,” he said.

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