It’s too soon to say whether this pattern can or will change in 2024, but it’s worth reviewing some of the factors which will bear on U.S. defense sentiment in 2024.

Having written this while the U.S. was under a continuing resolution, the first factor will be the outcome of fiscal 2024 appropriations. The first factor will be the outcome of fiscal 2024 appropriations. There remains a wide cone of uncertainty over what Congress will get done. The most positive outcome for defense would be the enactment of FY24 appropriations at or above the administration’s request, plus the supplemental request of $106 billion.

The most negative could be a fraction of the supplemental request and continuing resolutions that last into May 2024 without changes to the Fiscal Responsibility Act of 2023. That act resets the FY24 budget to 99% of the levels appropriated in FY23 (that’s base budget only, not emergency spending).

The eventual outcome may be somewhere between the best and worst cases.

The FY24 appropriations outcome will bear on long-term sales growth expectations. Per Bloomberg, estimates of consensus sales show mid-single rates of annual growth in 2025-2026 for larger U.S. contractors, and higher rates for smaller ones. Procurement as well as research, development, test and evaluation outlays — which mostly result from FY23 and prior fiscal year appropriations — show a peak growth rate of 15% in 2024. There is not a high correlation between percentage rates of change in outlays and Defense Department-related sales, but the two move in similar directions. The outlay data is supportive of consensus sales estimates.

But beyond 2024, it may be a different story. Investment outlays show 5% growth in 2025 and 0% in 2026, with those estimates reflecting the FY24 request but not a supplemental. Stocks tend to move up when analysts increase estimates, and down when the opposite happens, which is why Congress and FY24 is so important.

There are bound to be sell-side analyst reports that trot out data showing U.S. defense stocks tend to do well in presidential election years. However, the 2024 election might be different, or at least reinforce some of the factors that have weighed on U.S. defense in 2023.

If former President Donald Trump wins the election, it could significantly alter expectations for U.S. commitments to alliances such as NATO and for support of Ukraine. Those changes could be positive for European defense in 2025 and beyond, but could entail changes to U.S. export prospects and possibly DoD top line expectations.

If President Joe Biden is reelected, there is still the possibility of split-party control of the House and Senate — and with it, the partisan entrenchment that has weighed on budgets in 2023.

Operating margins and cash flows are other factors that shape stock behavior. Arguably, operating performance has been pretty good in 2023 given the pressures industry has faced from supply networks and labor. And while there have been pockets of execution issues, these have not been sweeping. Possibly these factors remain the same in 2024, but an issue will be the health of much smaller suppliers that are highly exposed to material inflation, labor issues and higher interest rates. Prime contractors might be able to manage these issues, but surprises are still possible.

Mergers and acquisitions may be limited to movement in small and midsize companies and continued portfolio shaping at larger firms. A change in the administration’s views that would encourage more consolidation among the largest firms seems highly unlikely given concerns over loss of competition, innovation and market power.

A final factor to watch in 2024 is how the competitive landscape changes and whether smaller defense technology firms can win programs enabling them to scale. If that happens, growth expectations could be recalibrated as these private firms either go public or appreciation of their market potential is confirmed. If it doesn’t happen, and funding sources dry up for defense technology, the competitive environment might be more benign.

Byron Callan is a managing partner of the research firm Capital Alpha Partners.

One of the surprises from the data is that 49 of the top 100 each reported a decline in defense sales from FY21 to FY22 (or 50 companies if you count Moog Inc., which saw a decline but was closer to a 0% change than -1%).

That may come as a surprise, but then this is generally a long-cycle business, and the translation of results from local currency to U.S. dollars is also worth considering.

Click here to see the Top 100, a ranking of the largest defense companies in the world.

The Russia-Ukraine war has led to defense spending increases, particularly in Europe, but it’s taking time for budgets to translate to sales growth. Part of this is the simple task of getting contracts let, but there are labor and supply network constraints to work through. The growth in 2022 sales by Ukraine’s Ukroboronprom isn’t likely to be matched by others given its wartime challenge, but European firms have been guiding investors and analysts to expect solid sales growth in 2023 and beyond.

On currency, to use one example, the U.S. dollar exchange rate at the end of 2021 was about 1.13 with the euro, but it was about 1.07 at the end of 2022 — a 5% decline. Standardizing data to the U.S. dollar is helpful, but it also may obscure underlying defense sales dynamics for non-U.S. companies.

Lockheed Martin remained the No. 1 company ranked by defense sales for a 24th straight year, and it’s difficult to see what will knock the company off that position unless there is a mega-merger among others in the top 10, or Lockheed Martin is broken up.

There were companies that, unfortunately, did not choose to report defense sales data, and others that dropped out as result of mergers and acquisitions or changes in ownership. Last year’s ranking included two different Indian defense contractors. This year, none are shown because defense sales could not be ascertained, but they remain factors in global markets.

Russian defense sales also were not shown. Only four Chinese defense firms are listed, but there are likely many more given the size of China’s defense budget. The Emirati firm Edge Group is also not listed. Ultra Electronics was purchased by private equity firm Advent International and is not shown, but had 2021 defense sales of $921 million.

For the U.S., SpaceX is probably in the top 100, and Amazon might also fit, but there’s no data on defense sales.

Given all the attention on defense technology companies, it’s also noteworthy that firms such as Anduril, Palantir and Shield AI have not made the cut, though that’s something to watch in the coming years.

One observation worth reiterating each year is that while there are a handful of defense firms with sales in excess of $10 billion, there are still many global competitors. The top 10 firms in this year’s list accounted for nearly 56% of the total top 100 defense sales, which is slightly higher than the 52% evidenced in last year’s rankings.

Firms based in the U.S. account for 51% of the Top 100, followed by European firms with 31%. However, defense is largely a multinational business. Elbit Systems and BAE Systems each report more sales for the U.S. than they do in Israel and the U.K., where their headquarters are respectively located.

Of course, the Top 100 will look different based on FY23 data, compared to FY22. Merger and acquisition activity will continue, and so it remains to be seen if Ball Aerospace and Austal are on next year’s list or end up with different ownership.

Others may drop off depending on their sales and the cutoff sales to make the Top 100 list. Oshkosh Corp. should still be listed in next year’s list, which tallies FY23 sales. But losing the Joint Light Tactical Vehicle re-compete may make that a challenge when the FY24 data is tallied.

Byron Callan is a managing partner of the research firm Capital Alpha Partners.

In reviewing the data that is available in this year’s Top 100, there are some takeaways and trends to consider.

Lockheed Martin again is ranked No. 1. Defense News’ data back to the 2003 list shows Lockheed Martin has consistently held that position. The ratio of its defense revenue to the No. 2 contractor listed, which for fiscal 2021 was Raytheon Technologies, was 1.5, which is slightly more than the 2003-2020 average of 1.4.

See the Top 100 list here

Barring another major merger or acquisition deal among the other top 10 contractors, or even a breakup of Lockheed Martin, it’s difficult to see how organic sales growth alone could knock Lockheed from it’s top position anytime soon.

Total FY21 defense revenue of the Top 100 is $595 billion, up 9% from the total FY20 defense revenue on this latest list. Of the approximate $53 billion increase, Chinese defense contractors accounted for $19 billion.

Twenty-two of the firms listed experienced negative comparisons of defense revenue on FY21 compared to FY20, but some of those declines can be explained by divestitures of defense operations. Similarly, acquisitions also contributed to defense revenue growth at BAE Systems, Leidos and Peraton, among others.

The Boeing defense revenue increase of about $2.7 billion stands out because the company reported $26.5 billion in 2021 revenue for its Defense, Space and Security segment. In 2020, it reported $26.3 billion in revenue for this segment. Boeing does not report defense and commercial revenue in its Global Services segment, so it must have had a much stronger defense contribution in FY21 than FY20.

The data shows that globally, the contractors are fragmented. That may not be the case in individual country markets where there are national champions and some segments are more concentrated than others. The top 10 contractors for FY21 accounted for 52% of defense revenue for the Top 100. That’s a bit lower than the average of 56% reported in the 2003-2020 data sets.

There has most certainly been consolidation, notably in the U.S. sector, but then there are new emerging global competitors and national champions. South Korea’s defense contractors are more active in markets outside of Asia, and this has been underscored by recent defense sales announced to Poland. The inclusion of Polish Armaments Group and Saudi Arabian Military Industries are other manifestations of this trend.

For all the focus on defense innovation and the emphasis on broadening defense-industrial bases, a glaring absence of the list are new entrants. Possibly, SpaceX could be included, but while there are some U.S. defense “unicorns” with $1 billion valuations, their sales are still far below the $600 million level that’s the entry threshold to the Top 100.

It’s probable that the Top 100 will see larger defense revenue figures in FY22 and beyond. Defense spending growth in Europe, the U.S. and Asia is increasing, and so too will contractor sales. Mega defense mergers are unlikely, particularly in the U.S., given the Biden administration’s focus on competition, and action on the Lockheed Martin-Aerojet Rocketdyne merger signaled tougher stances on vertical integration.

However, smaller deals are likely to continue, and so there could be more churn in the lower 50 of the Top 100. The largest contractors will likely continue to assess their optimal portfolio mixes, and divestitures will continue.

Byron Callan is managing director at Capital Alpha Partners, an independent research firm.

Lockheed Martin remained the largest contractor, which has been the case since the annual list was published in 2000. Consolidation resulted in movement among contractors, with Raytheon Technologies knocking Boeing off its No. 2 position. Finally, U.S. and Chinese firms dominate the Top 10, reflecting the size of those governments’ respective defense budgets.

But here’s what I found noteworthy about this year’s list:

1. Some prominent suppliers are missing. Unfortunately, all contractors don’t respond to the Defense News survey, notably General Atomics and SpaceX, as well as some suppliers that would appear to clear the lowest-ranking sales figure on the list. Triumph Group is one example. Some of the firms taken private have also dropped from the Top 100, notably Cobham, which was purchased by Advent International in 2020.

For non-U.S. contractors, there also some that could show up in the Top 100, including several Russian and Chinese contractors, the Polish Armament Group, and possibly Taiwan’s Aerospace Industrial Development Corporation.

2. Defense News added some more services contractors. This year’s list includes two federally funded research and development centers — Mitre and Aerospace Corporation. This raises the question, however, of where to draw the line between private, nonprofit and state-owned enterprises. Naval Group of France is included in the list, and Chinese firms are state-owned, though they may have multiple subsidiaries listed on stock markets. The U.S. Department of Defense operates logistics centers, shipyards, depots and arsenals. If government-owned shipyards compete against the private sector for ship repair work, they arguably are a market factor, too.

3. For all the interest defense establishments have in fostering innovation and new ideas, no new startup in recent years has made it into the Top 100. SpaceX could be the one, and others, such as Palantir or Turkey’s Baykar, may have a crack at this in the 2020s. But contrast defense to other high-tech or engineering sectors where new entrants are reaching scale and are shaking up the old guards. For the DoD in particular, it has not supported a new entrant that has been able to scale to a sales level that would entail inclusion in the Top 100. Doing so could well spawn significant additional capital inflows to support defense/security startups.

4. Not all contractors increased sales in 2020 compared to 2019. The total sales data from fiscal 2020 is not comparable to fiscal 2019 because there are eleven firms included in this year’s list for which there is no fiscal 2019 data. United Technologies Corporation and Raytheon Company were listed in last year’s rankings, but there were divestitures to BAE Systems with the formation of Raytheon Technologies. Still, it’s noteworthy that not all contractors increased sales in FY20 compared to FY19.

5. Consolidation has been an enduring theme and continues to reshape the sector. However, it remains to be seen how the Biden administration will assess further consolidation in defense. The Top 100 suggests a fragmented market, but that’s far from the case in some segments where a handful of suppliers or primes exist. The services sector, however, is an exception, and the Top 100 suggests further consolidation is probable.

Byron Callan is a policy research expert at Capital Alpha Partners. He specializes in the defense and aerospace industries.

The rankings among U.S. firms have been relatively stable, with the primary catalyst for several years worth of change being acquisitions or divestitures. The U.S. order will again change in next year’s edition, when Raytheon Technologies appears as a single entity for the first time. Defense News added Chinese enterprises in 2019, and so it’s good to see this extended in 2020, as China has the second largest defense budget in the world after the U.S.

This year’s list raises six points worth highlighting, while observing how relative rankings have changed over time.

First: These lists are difficult to compile, as they depend in large part on the willingness of contractors to provide sales data. There are some omissions, which hopefully could show up in future rankings — notably, BWX Technologies, SpaceX, General Atomics, Mantech, Parsons and Kratos for the U.S.; more Japanese firms including Kawasaki Heavy Industries; Navantia of Spain and other European naval shipyards; United Aircraft in Russia; ASC Pty in Australia; and PGZ in Poland. There are other Indian firms as well that would likely qualify.

Click here to see the Defense News Top 100 list.

Second: It is intriguing to note how long either Lockheed or its successor Lockheed Martin has been the No. 1 U.S. contractor. It’s been at the top of the Defense News list since 2003, and data from annual reports show it has been the top U.S. contractor, by sales, since 1980. Size may matter in perpetuating a No. 1 position, so it is notable that the ratio of Lockheed’s defense sales to the second-largest contractor has also increased over the years. For this year’s list, Lockheed’s defense dollars are 165 percent of Boeing’s defense sales; in 1988, they were 130 percent higher than the next largest defense contractor, McDonnell Douglas.

Third: As much as it’s easy to categorize contractors by their home country, it bears repeating that this a global, multinational business with international sales not just from exports. A look at the Australian defense industry highlights the “multi-domestic” nature of contractors in that country. BAE Systems is listed as a U.K. company, but it derives higher annual sales from the U.S. and Saudi Arabia than from London. And in 2019, Israeli firm Elbit had more of its total sales from North America (28 percent of total) than Israel (24 percent of total).

Fourth: While the rankings don’t capture the changes in the composition of some of the largest contractors, this may have a bearing on competition in the 2020s. CACI and Leidos still are predominantly services contractors, but some of their recent acquisitions, most significantly the Leidos acquisition of Dynetics, are more product-centric.

Fifth: Obviously the rankings only capture the top level of the global defense sector, and in assessing supply chains, resiliency, the pace of innovation and technology ingestion, a far wider net has be cast. A July 2020 report by Israel’s INSS observed that Israel’s defense industry, which has seen consolidation in recent years, is comprised of “about 600 companies” and employs over 45,000 workers. Much as the rankings of the top contractors are of interest, a more critical assessment of the health and agility of contractors may rest on what’s happening with smaller firms.

Finally: The question of state, private or public ownership is a sixth factor to weigh. State ownership of Chinese firms and partial government stakes in some of the largest European enterprises has entailed different incentives and goals — it’s hard to conclude, given the nature of China’s rise, that government ownership of contractors has stymied the development and production of competitive weapons systems, though there’s little transparency on efficiency. In the 2020s, it remains to be seen how different and competing ownership shapes future rankings.

Byron Callan is a policy research expert at Capital Alpha Partners. He specializes in the defense and aerospace industries.

Some planners and analysts may scoff at the inclusion of Chinese firms, or for that matter enterprises of other countries that don’t have markets open to U.S. and European firms. But this raises the first of three lessons that can be learned from the Top 100: Pay attention to China.

The U.S. Defense Department and other defense ministries have been paying a lot of attention to China for more than a decade, and contractors have undeniably benefited from spending to counter China’s emerging defense capabilities.

The data listed in the Top 100 for eight Chinese enterprises raises a host of questions: Are these firms profitable? How much do they spend on research and development? What are management incentives and goals? How do these firms benefit from commercial enterprises that are often part of their business portfolios?

A recent McKinsey & Company study observed that the largest 100 Chinese firms in all sectors generated approximately 18 percent of sales internationally, compared to 44 percent for U.S. firms in the broad S&P 500 market index.

The same relationship may hold for China’s defense contractors. China’s major defense export customers have tended to be relatively small in number — Pakistan, Bangladesh, Thailand, Myanmar and some African states.

There are harbingers of change, however, with a Chinese firm selected in 2013 to supply Turkey with an air defense system (the deal fell through) and more recent UAV and ballistic missile sales as well as local development for Saudi Arabia. It’s likely that companies listed in the Top 100 will see more Chinese enterprises in global markets in the years to come.

The second lesson from the Defense News rankings is that it’s difficult for contractors to make significant moves on organic sales growth alone. Lockheed Martin has been the No. 1 ranked company since 2003; Boeing, Northrop Grumman, Raytheon, General Dynamics and BAE Systems have been ranked between No. 2 and No. 6.

There are two possible exceptions to this rule, however, in SpaceX and General Atomics, neither of which appear on the Top 100. There’s been a general dearth of new entrants in defense that have reached scale. Big moves in relative position have typically resulted from divestitures, or mergers and acquisitions .

For contractors that are on the list, this leads to a third lesson: The things you can’t see may kill you, or at least trip up your well-laid plans.

SpaceX is possibly an anomaly, as there are not that many billionaires with very different business models and goals targeting specific defense segments. But defense customers will continue to demand new and innovative products and services, and the number of potential competitors is far greater than those listed in the Top 100. The threats here may come from smaller firms that can rapidly scale up in new market segments — such as space, cyber or artificial intelligence — or protracted forays by large commercial technology firms into markets dominated by traditional contractors.

There are other companies not listed in the Top 100 that will play impactful roles in defense market segments. The initial public offering of Parsons raises its profile in defense. Kaman’s plan to sell its distribution business and concentrate on engineered products is another change, and the agreement between AeroVironment and Kratos announced in 2019 is another factor to weigh.

Byron Callan is a policy research expert at Capital Alpha Partners. He specializes in the defense and aerospace industries.

How the gap between resources and strategy is closed is a central issue for 2019. It’s highly unlikely that the DoD would opt to take an entirely different track in its assessment of the global security challenges the U.S. confronts. The Army, Navy and Air Force have all loudly signaled that they need larger-size forces to address challenges and deter adversaries and competitors. But the resource gap suggests that something will have to change.

Stock market investors partially figured this out in 2018, but the treatment by markets of large U.S. contractors has been uniform. Sales growth for the vast majority of defense contractors should be just fine for 2019-2020, but that’s a reflection of the largesse provided by Congress in the fiscal 2018 and fiscal 2019 DoD budgets. If the 2020 and 2021 budgets prove to be flat compared to 2019, that will translate to lower and possibly minimal sales growth in 2021-2022.

Outlook 2019: World leaders and analysts speak on the state of global security and the defense industry

The mid-upper single-digit stock price declines evidenced so far in 2018 from year-end 2017 levels reflect recognition of this likely sales trend. However, there does not appear to be all that much differentiation, as far as investors are concerned, among the largest contractors. Valuations on consensus financial estimates and stock price behaviors have been uniform.

For contractors, the most attractive option will likely be to prepare to hunker down and retrench. This entails riding out the current sales wave, but then scaling back capital expenditures and beginning to plan for cost cuts and headcount reductions in the early 2020s. It may entail using even more free cash flow to shore up earnings per share through share buybacks; and in order to maintain operating margins, cuts to research and development could also be pursued. This may be the easiest path for managers to take, but it might also prove the riskiest.

Retrenchment strategies could be the riskiest because the DoD will be searching more fervently for ways to close the gap between resources and the challenges outlined in the National Defense Strategy. Opting to cut force structure and proceeding with current programs of record may simply widen the gap. Equally, trying to sustain current modernization programs and sustain force-size goals could cut readiness and again bring back the risks of hollow military forces.

The fervent search for sustained military capability will place even more emphasis on investments that increase the “productivity” of the DoD. In commercial businesses, productivity improvements can be made from investments in automation, reduction of overhead costs and the leaning out of processes. Technology plays a clear role, but so too does organizational and cultural change.

There are clear analogies for how this thinking could play out in the Pentagon. The thinking has been there, and there are already a number of initiatives underway, but the question is how they are resourced.

Contractor retrenchment may make incumbents even more vulnerable to loss of program and market share to current or new contractors who can offer the DoD the products and services to help close the gap. Minding the gap means taking more risk in 2019-2021 in terms of product and service development — and if not, possibly making decisions to exit business segments where risk could be highest.

Investment might entail some risk to operating margin, or redirecting cashflow from share buybacks to venture or partnership investments. A key to superior financial performance in the 2020s could come from taking share away from other contractors. The gap may make that a more fruitful strategy.

Byron Callan is a policy research expert at Capital Alpha Partners. He specializes in the defense and aerospace industries.

Rankings data back to 2003 underscored a prominent, enduring characteristic — namely the stability among the top 10 companies. Lockheed Martin as always been ranked No. 1 in terms of sales. Unless there is merger among two or more of the other top 10 companies or Lockheed Martin is broken up, it’s hard to see how this position will be challenged for years to come. The F-35 program is still growing, and missile and missile-defense production is increasing. The CH-53K should transition from development to production.

Lockheed Martin’s relative position increased in 2017 compared to the next largest defense contractor. For 2003-2016, its defense sales had risen from 10 percent greater than the No. 2 ranked firm to 47 percent greater in 2016. In 2017, its defense sales were twice as much as the No. 2 ranked firm.

See this year’s Top 100 list!

For all the talk of rapid acquisition and the U.S. Defense Department’s desire to bring in more nontraditional contractors, none of this is showing up in the Defense News listing. SpaceX is not listed, but that’s only one possible candidate; their defense-related launch sales should be entering a range that would merit a listing. Obviously, the sort of engagement that the Defense Innovation Unit Experimental or other rapid acquisition outreach organizations undertake at the Department of Defense or other ministries of defense wouldn’t show up in a listing where the one-hundredth ranking firm has $194 million in defense sales. But possibly, that changes by 2020-2022.

The biggest gap in the Top 100 remains the absence of Chinese defense enterprises. If China has the second-largest defense budget in the world after the U.S., then there must be five to 10 enterprises that could be included in the listing. As China privatizes more of its enterprises that provide defense products and services, there should be data that can be added to the Top 100.

There are other global enterprises that are not listed but that may matter more in years to come as the industry evolves. Poland’s PGZ is one example, and aspirations of the United Arab Emirates and Saudi Arabia to build their respective defense sectors also matter for any contractor that competes in those domestic markets, and globally. PGZ is a defense exporter, and so competition outside of Poland as well as the UAE’s ties with Turkish and American contractors are another factor to consider in how global defense trade is changing. Cooperative programs, such as the Serbia-UAE ALAS system that has been sold to Pakistan, are developed and produced by enterprises that aren’t on the Defense News list, but that are likely to be greater competitive factors in the coming years.

The list begs that question of scale needed to compete in defense. There’s no one-size-fits-all answer here. With U.S. defense and federal services, the General Dynamics-CSRA acquisition reinforced beliefs that optimal scale had moved from approximately $5 billion in annual sales to $10 billion. But in other sectors, just being big or bigger may not ensure competitive success in defense. That doesn’t mean either that “small is beautiful” and that the companies at the bottom of the Top 100 are destined to inherit the future; however, small, innovative firms will continue to be the object of attention by larger contractors.

There are two other factors to weigh in thinking about how rankings could change in 2018-2021. One is increased trade protection and the impact of tariffs and quotas. For the U.S. and European firms, defense has mostly been an export business. Products are built in the American states of Missouri and Texas, or France, and are exported. There are some “multi-domestic” business models — BAE Systems is one example, and General Dynamics Land Systems Europe is another. Countries typically have wanted offsets to their defense purchases, but there has been more focus on preserving or enhancing domestic sources of defense capability in Australia, Canada, Poland, Romania and the U.K.

The other is currency. This has always been a factor in any series of sales data where local currencies are converted to U.S. dollars. The 2017 inclusion of Almaz-Antey in the top 10 was more a function of currency translation than a surge in Russian rouble-based sales. Its 2017 defense sales were about the same in U.S. dollars, as reported by Defense News for 2014, when defense sales of $9.2 billion were reported. However, in Russian roubles, sales were 7 percent higher than in 2016 and almost 50 percent higher than for 2014.

Short-term swings in currency are unlikely to impact decisions on what weapons or services to buy or where to locate facilities. But longer-term trends in the relative strength of the U.S. dollar, or euro, or British pound could bear on how industry is globally configured.

Byron Callan is a policy researcher at Capital Alpha Partners and is an expert in financial and defense industry analysis.

Defense M&A increased in 2017 compared to 2016, and it was comprised of a mix of deals whose rationale could be extrapolated into 2018 to divine what else could occur. The largest was the Northrop Grumman-Orbital ATK deal, which underscored large primes’ desires to reposition into growth markets. (There were other large deals, notably between United Technologies Corporation and Rockwell Collins as well as Safran and Zodiac, but their rationale was mainly based on commercial aerospace.) Consolidation continued in defense services as exemplified by KeyW’s purchase of Sotera and the deal between Vencore and DXC Technology. Private equity continued to be a buyer and a seller. The Vencore deal is one example of an exit, while Veritas’ purchase of Harris Corporation’s government information technology business is an example of a purchase. There were lots of smaller bolt-on acquisitions to gain access to technology, new customers or both.

Outlook 2018: Perspectives from global thought leaders

Defense sector M&A could accelerate in 2018, and deals will be struck on the same rationale evidenced in 2017. Record-high stock prices and the valuations they represent make share buybacks less impactful. There inevitably are going to be different views on the trajectory of defense budgets to the early 2020s, and managements and boards may either conclude this is as good as it’s going to get or that the best times for defense are still ahead in the future. Those dispositions are what make deals for buying or selling.

But there are other factors and issues that could alter the path of defense M&A, and they should be considered by contractors, their customers, suppliers and competitors.

The first factor is whether M&A can enable defense contractors to better ingest commercial technology. The disparity in defense versus commercial research and development has only widened in recent years, and commercial is the driver in areas such as autonomy, data analytics and machine learning that are of keen interest to militaries. Partnerships and ventures may be the better path here, as most managements seem loath to consider entering commercial markets and there are valid security, overhead and cultural issues to consider.

Second is the preference for “Buy America.” U.S. defense firms have generally not been truly multinational with globally distributed development and manufacturing operations. Supply-chain issues and potential blowback from Buy America might result in more M&A activity geared at accessing regional trade areas or individual countries.

A third factor is whether there may be another attempt to build a defense firm that is larger than Lockheed Martin, which is the No. 1 ranked firm by defense sales per Defense News’ “Top 100” rankings. Large primes might again attempt to merge, though the last time a deal like that was tabled was in 1997 when Lockheed Martin tried to buy Northrop Grumman. The U.S. Justice Department case blocking the AT&T deal to by Time Warner suggests that government remains wary of giving companies too much power over market segments and there may be a read-through for defense.

Portfolio simplification is a fourth factor, and a related fifth factor is the culling of business segments that may spur more commercial competition. In the case of the former, managements increasingly focus on what their companies do best and divest subpar performers or businesses outside of core skills. This factor will become more important as defense investors expect growth. Commercial space and cloud services are areas where heritage defense firms will face more competition from firms with different business models, risk tolerance and cultures. This could trigger reassessment of what belongs in a defense contractor’s business portfolio.

Byron Callan is a policy research at Capital Alpha Partners, LLC and is an expert in financial and defense industry analysis.