Defense margins continue to remain resilient despite top line pressure. While strong execution and an improved mix have contributed, restructuring, principally large headcount reductions, has been the main driver of margin performance.
Large-cap defense contractors include General Dynamics Corporation (NYSE: GD), Lockheed Martin Corporation (NYSE: LMT), Northrop Grumman Corporation (NYSE: NOC), Raytheon Company (NYSE: RTN) and Boeing Co. (NYSE:BA).
"We estimate that on average the large defense companies have reduced their headcount by 16% from peak back to levels last seen in the early 2000's as compared to a 4% revenue decline (before adjusting for acquisitions and divestitures)," UBS analyst David Strauss wrote in a note to clients.
In absolute terms (unadjusted for acquisitions and divestitures), Northrop Grumman has reduced its headcount the most at 23 percent followed by Lockheed Martin (21 percent), Boeing (13 percent), Raytheon (9 percent) and General Dynamics (8 percent).
However, adjusting for large acquisitions and divestitures changes the picture. On this basis, GD has actually reduced its defense headcount by approximately 19 percent on an organic basis as compared to just 8 percent in total, more closely in line with its organic revenue decline. Meanwhile, Lockheed's and Northrop's organic headcount reductions are smaller after adjusting for divestitures as Raytheon has cut by 12 percent organically as compared to 9 percent in total.
Meanwhile, defense productivity or revenue per employee increased 15 percent for the group since 2009 when industry downsizing began. LMT's productivity has increased the most over this period (+30 percent) followed by BA (+17 percent), NOC (+16 percent) and RTN (+11 percent) while GD's (defense) productivity has declined (-4 percent).
"BA has the highest revenue per employee at ~$445K, which we attribute to a relatively small labor intensive service business," Strauss said.
With restructuring (including reducing hea! dcount), defense companies establish a new cost baseline on which future contract pricing will be based. This enables margins to move higher initially on restructuring, although cost savings will eventually be passed onto the customer in the future as contracts reprice.
"While margins benefit initially from restructuring, lower actual costs in the current period become the basis for lower estimated costs in future contract negotiations. If contracts re-price ratably over three years, margins return to historical levels over the same time frame," Strauss noted.
Under cost plus contracts, the initial margin benefit is smaller with margins reverting to historical levels just as they do under fixed price contracts. While severance costs initially offset some of the benefits from restructuring, severance costs are allowable costs of doing business with the government, meaning that they are reimbursed immediately under cost type contracts and reimbursed over time on fixed price contracts.
"We believe accelerating revenue declines to come along with the repricing of contracts to reflect lower cost structures will pressure margins," Strauss added.
While companies capture the benefit of cost reductions on fixed price contracts, as opposed to cost reimbursable contracts where the savings go back to the customer, eventually their lower cost structures are reflected in lower pricing on follow on fixed price production contracts.
Despite revenues under pressure, margins for the industry have moved higher. Since revenues peaked in 2010, margins overall have increased slightly to 12.2 percent over the last twelve months (LTM) from 11.6 percent as companies have benefited from larger EAC (estimate at completion) adjustments.
The headcount reductions have positively benefited EACs. Excluding EAC adjustments, industry margins have held relatively flat in the low 9 percent range.
"By company, LTM margins ex adjustments have increased since 2010 for NOC (+60 bps), RTN (+30 bps), an! d LMT/BA ! (+20 bps) while declining for GD (-110 bps)," Strauss said.
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