Defense Industry Profits Are Doing Well, But...
In my SIGNAL blog back in June, I commented on how the 2015 release of Fortune Magazine’s listing of the top 500 American firms showed the defense industry has been steadily shrinking over the past half century. As I mentioned in that post, when President Eisenhower, in his January 17, 1961 farewell address to the nation, raised his famous concern about a growing “military-industrial complex,” this industry was indeed a major—and new—presence on the U.S. industrial landscape. But a careful review of the top 100 companies on Fortune’s list between 1961 and today reveals just how much has changed over the half century since the president’s speech, and some of it suggests subtle messages about where we might be going from here.
As I noted in June, in 1961, the Fortune 100 contained 15 companies that were either exclusively or heavily involved in the defense program. These 15 companies accounted for about 30 percent of the annual revenue being generated by the Fortune 100 companies, showing that they were indeed a major economic and financial presence. Interestingly, however, in 1961 these companies were not making any money. In fact, as a group they were operating at a loss.
Why was this the case? One would have to have intimate knowledge on the products, performance and contract terms of the period to answer that question definitively; but low margin performance would not be unusual for a new industry attempting to establish its position in the market and develop an understanding of the needs of the customer. Nonetheless, no company in any industry can stay in business very long unless it begins to generate earnings allowing it to both cover its costs, permit investment in capital expenditures and research, and—if a publicly traded company—compete for investors in the equity markets.
A decade later in the 1970s, as the nation struggled with numerous challenges in the world, including an unpopular war in Vietnam and a threatening Soviet Union, U.S. defense companies were profitable—but barely. Those companies in the Fortune 100 that were partially in defense were showing a profit margin that was less than a third of the overall Fortune 100, while the pure defense companies were recording a margin less than a fifth of the other companies. But beginning in the early 1980s with the Reagan defense build-up, things begin to get interesting involving comparative profits and margins.
Starting in 1981, those companies that were partially in defense began to close the margin gap existing with other Fortune 100 companies, while the pure defense companies continued to lag far behind. But by 1991, the overall defense industrial base essentially matched the margin performance of the Fortune 100 and continues to do so. Pure defense companies, by contrast, lost ground in the 1990s as the industry consolidated following the end of the Cold War. As the 21st century arrived, they were recording margins only a quarter of the overall Fortune 100. But since then, things have changed.
A review of the latest Fortune 100 shows that the profit margins being recorded by the defense industry—those companies that are partially and primarily in defense—match those of the overall Fortune 100. Indeed, they are slightly ahead. How did this happen and what does it mean?
It happened for many reasons, including the entry into the Fortune 100 of several large revenue but small margin companies. The largest company in the entire Fortune 500 is Wal-Mart with annual revenues of $486 billion (roughly the size of the annual defense budget under sequestration caps), but earnings of only $16 billion—meaning a margin of 3 percent, less than half of the overall Fortune 100 margin for 2015. So, part of the change would be in the composition of the companies in the Fortune 100.
But for the defense companies themselves, much of this improved performance is attributable to the fact that senior executives who are significantly more attuned to financial performance than their predecessors now run these companies. They have much more in common with Jack Welch, the legendary CEO of General Electric who focused on shareholder value and returning earnings to investors, than they do with Jack Northrop, who primarily was interested in building the next technologically breathtaking airplane. Whereas the early leaders of the defense industry were almost all engineers, many of the current senior leaders are not, coming from a financial management background. Former General Dynamics CEO Nicholas Chabraja was a corporate lawyer by training and had no engineering background, while former Northrop Grumman CEO Ron Sugar started his career in engineering but moved over to the financial side during his professional journey, once serving as the CFO of TRW.
Is this a bad change? No, it is not. The nation needs a steady, stable, successful defense industrial base; and because the major players in the industry are publicly traded entities, they need to be profitable to attract investment and capital. Unprofitable companies are unhealthy companies whose long-term prospects are, at best, uncertain. But given the pressures placed on senior industry leaders by shareholders to perform—to grow annual revenue, to increase earnings and to improve margins—the government has an interest in their success. This means it should expect more corporate moves such as United Technologies' recent decision to sell Sikorsky (with a 7 percent margin) to Lockheed Martin so that it could focus on its more profitable—by a factor of two—commercial units. For its part, Lockheed Martin is paying for the acquisition by selling a low margin services business—lower than Sikorsky’s 7 percent.
Some in government are uncomfortable with high, double-digit margins. They view higher margins with a degree of suspicion, seeing it as a cost they don’t want to pay, rather than an important metric of success. They need to recognize that defense companies now are run by a different type of leadership—one that is highly sensitive to the demands of capital markets and investors. This is a change that needs to be accepted and accommodated. In the words of the great U.S. philosopher Willie Nelson, “It ain’t wrong, it’s just different.”
M. Thomas Davis is a former corporate vice president with General Dynamics Corporation and a past assistant professor of economics at West Point, the U.S. Military Academy.
