What lies ahead for defense contractors in 2014

Correction: A previous version of this article incorrectly attributed a detail about a $10 billion General Dynamics training contract with the Canadian government’s commercial contracting agency. It was the Canadian agency, not General Dynamics, that identified Saudi Arabia as the customer that ultimately received the training services. This version has been corrected.


Lockheed Martin’s headquarters in Bethesda, Md. (Andrew Harrer/Bloomberg)

Washington defense firms Lockheed Martin, General Dynamics and Northrop Grumman last week released their first earnings reports of the year. The results were largely mixed. All three posted higher profits, but sales plummeted in the combat and information systems segments as the government’s defense budget continued to shrink. Company executives had warned that 2014 would bring budget challenges and political wrangling.

Here’s a roundup of what to expect this year and how contractors are adjusting their priorities, according to industry analysts.

International shift

As domestic demand dries up, contractors are expecting more business from foreign customers in 2014.

“The U.S. taking its boots off the ground has created enough of an incentive for our allies to begin arming themselves,” said Jason Gursky, an analyst at Citigroup.

The Middle East and parts of Asia are driving demand, he said. In its earnings report, General Dynamics noted a $10 billion training contract with the Canadian government’s commercial contracting agency. The ultimate recipient of that order is Saudi Arabia.

This global shift will help offset some of the drop in U.S. orders, analysts say, but it won’t be enough to make up for it.

Lockheed will benefit from increased orders for its F-35 fighter jets, and General Dynamics from orders for the commercial Gulfstream jet, analysts say.

Northrop Grumman’s chief executive, Wes Bush, told investors that global orders made up 14 percent of the company’s year-end backlog in the first quarter. Bush said he expects growth to continue in 2014.

But foreign contracts “are notoriously difficult to time, to peg when they will come through,” said Cai von Rumohr, an analyst with Cowen and Co. So even though international business will expand, it may not make its way onto companies’ books until late in the year.

Northrop has a higher potential for growth than Lockheed or General Dynamics, analysts say, given that it has a smaller share of global business. Northrop is betting on increased interest in unmanned aerial vehicles, especially its Triton and Global Hawk systems, von Rumohr said.

Alternate revenue streams

Many contractors will invest in other segments of their business in 2014, turning their focus away from defense, analysts say.

General Dynamics’ aerospace sector was the only one to grow in the first quarter, because of orders for Gulfstream business jets, the company said.

Gulfstream will continue to be the key driver of future returns, said Loren Thompson, a defense analyst and consultant to Lockheed Martin.

Phebe Novakovic, chief executive of General Dynamics, said in a call with investors that she “liked the balance” between the company’s aerospace and defense operations.

Lockheed has started diversifying into many areas, Thompson said, from cybersecurity to aquaculture to pilot training.

Bush recently said that Northrop was less interested in chasing new markets, and preferred to focus on what it does best.

A rocky road

All three defense giants reported a drop in sales for the information systems and technology segments in the first quarter. Washington’s latest jobs report also showed that the professional services sector, which includes government contractors, shed 11,500 positions for the one-year period ended in March.

The good news, according to analysts, is that information systems and technology will start growing again. The bad news — that growth won’t be evident until at least 2015.

“We’re going to be reaching the bottom pretty soon if we haven’t already,” said Gursky, the Citigroup analyst.

Although the bipartisan budget deal reached late last year provided some certainty to contractors, the effects of the agreement haven’t been felt yet, analysts say.

Novakovic said that General Dynamics expects growth in its health-care services sector, but that it is a largely seasonal business. The contractor acquired health-care technology firm Vangent for $960 million in 2011.

Cost-cutting, returning cash

Shareholders can expect even more returns from contractors in 2014. As companies cut costs and try to keep their operating expenses down, they will have more cash in hand to give away, analysts say.

“That’s why their stocks have been doing well despite the headlines,” Gursky said.

Overall, this will be a tough year for defense contractors, just like the previous one. But if companies can make it through 2014 with no major surprises out of Washington, the worst could soon be in the past.

Amrita Jayakumar covers federal government contracting for Capital Business, The Post's local business publication.
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