In late January, the U.S. Air Force had some bad news for Lockheed Martin Corp. (LMT): The world's largest defense contractor would earn no profits in 2004 or 2005 on a satellite system it is building to provide early warning of missile launches. Because of the skyrocketing cost, from $1.8 billion to $5.6 billion, of the Space-Based Infrared Systems-High program, $10 million in fees are being deferred. The Pentagon will cover the overruns, but the Bethesda (Md.) company's profits, pegged to the original price, remain capped at $200 million through 2011. That's a 3.6% margin at best and not much lower than the 5.6% overall margin Lockheed made in 2004 -- $2 billion in profits on $35.5 billion in sales.
Nearly 1,000 miles to the west, margins are considerably more lush at $3 billion Rockwell Collins Inc. (COL) The Cedar Rapids (Iowa) maker of aviation electronics sticks to safer jobs such as the $600 million upgrade of the Air Force's KC-135 refueling tanker. Rockwell is replacing navigation and communications gear on the aging planes, often with off-the-shelf products such as weather radar that it also sells for commercial aircraft. While the company won't disclose margins on individual programs, execs say its tanker deal is typical of its defense jobs, where profit margins exceed 18%.
"POLITICAL RED FLAGS"
To the public, all military contractors are alike: big, politically connected, and fabulously profitable. But as Lockheed and Rockwell demonstrate, there's a split in the industry. Not-yet-published data compiled by the Center for Strategic & International Studies and obtained by BusinessWeek show that suppliers have higher profits as a percentage of sales than the titans. From the Reagan buildup in the 1980s through the Bush surge in 2004, prime contractors averaged 6.3% profit margins, vs. 8.5% for subcontractors.
Wall Street tolerated the primes' record for much of that period, with value funds treating them like utilities -- steady income producers -- while the zippier suppliers show up in growth funds. "The [primes'] cash flow is enormous," notes Frank C. Lanza, CEO of supplier L-3 Communications Holdings Inc. "[And] they have no risk" because costs are reimbursable. But with defense procurement slowing, investors may get wary. "I have negative ratings on most of the large, integrated defense contractors," says Robert Friedman, an analyst at Standard & Poor's.
Despite their enormous political clout, such household names as Boeing (BA), General Dynamics (GD), and Northrop Grumman (NOC) are under Washington's microscope and have to be content with microscopic margins. High margins "raise political red flags," says John Montgomery, managing director of Montgomery Brothers Inc., a Washington investment-management firm.
Suppliers -- and their richer profits -- fly under Washington's radar. They can spread development costs across commercial and military sales. Subcontractors are "a lot more commercial, a lot more responsive, and a lot more efficient," says Gordon Adams, a defense expert at George Washington University. That's one reason for the 136% jump in Rockwell's shares since Jan. 1, 2002, which dwarfs the 34% rise for Standard & Poor's Aerospace Index. The suppliers also are merging to gain more clout in negotiations with the big guns: The number of middle-market mergers rose 33.8% in 2004 and is climbing at a 63.4% annualized clip, according to Jeffries Quarterdeck, a unit of Jeffries Group Inc.
The diverging fortunes of Lockheed and Rockwell show how the industry has evolved. For the primes, new contracts to build planes and ships are scarce these days. So when one goes out for bid, "you've got to win it," says an executive familiar with Lockheed Martin's thinking. That forces companies to lowball their bids. With good performance, a prime contractor can collect fees of up to 14% of costs -- but those are calculated on the initial bid, and margins drop as costs inevitably rise. And those hard-won contracts seldom lead to the long and profitable production runs promised. Lockheed Martin was supposed to build nearly 800 F/A-22 Raptors, for example, but the order now is well below 200.
Subcontractors, in contrast, get paid a fixed price. "Any efficiencies you get to keep," says Rockwell Collins CEO Clayton M. Jones. Fewer contracts now impose special military specifications, which produced those infamous $600 toilet seats. So Rockwell Collins can use the same production lines as it splits its business evenly between government and commercial work and between domestic and international markets. Suppliers also enjoy healthy sales in upgrades and parts.
To remedy their sluggish image, woo investors, and shift risk, the primes want to jack up profits while shrinking the capital they commit. Lockheed Martin boosted return on invested capital from 6.1% in 2002 to 11.9% in 2004, largely by cutting debt. And in a Jan. 13 internal memo, Lockheed Martin Chief Financial Officer Christopher E. Kubasik told execs that capital should be invested only as a last resort. Such strategies could spark a struggle between the primes and subs over who foots the investment tab, since the goal for both is to earn more money with lower capital outlays.
The Pentagon is helping this push by the primes by hiring them to serve as "lead systems integrators" (LSIS) for defense programs. The idea: let contractors use their expertise to buy rather than build components and stitch together complex weapon systems. The prime contractor mostly sells brainpower, while suppliers make the heavy investments. For the LSI, "a 6% margin on zero investment is a heck of a good return," says Daniel J. Murphy Jr., CEO of Alliant Techsystems Inc. (ATK) in Edina, Minn., a maker of munitions and propulsion systems.
NEW STRATEGY, IFFY RESULTS
The LSI approach explains how Lockheed Martin -- which doesn't own a shipyard -- can vie for lead contractor on the Navy's new shallow-water ship. And why Boeing, which doesn't build tanks, is the lead on the Army's $100 billion-plus Future Combat System, a collection of combat vehicles linked by a high-tech network. But there's growing disenchantment with the LSI idea. The Army has restructured the Future Combat System to cope with technical and cost woes. "This is not regarded as a success," says one Pentagon insider.
While the primes want to emphasize their improved return on investment, the subs are beating them at that game, too, according to the CSIS data. And they're not likely to let the primes drag down their margins. All of this raises the question of who will make the investments needed to preserve the nation's defense industrial base. Until that question is answered, the smart money is riding on the little guys.
By Stan Crock in Washington