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U.S.A.: Arms Makers Find Themselves Cash-Heavy from Defense Spending
Top military contractors have about $25 billion to $30 billion in cash sitting in their coffers. Fully, indebted to the government for their revenues resulting form record Pentagon budgets and spending on homeland security, shareholders are happy and stocks are reaching new highs.
by Leslie Wayne, The New York Times
The nation's military contractors are awash in cash, which is making their shareholders happy and pushing their stocks to new highs. Less happy, however, is the Pentagon, which is the source of much of that cash and may now want something in return. At the moment, about $25 billion to $30 billion is sitting in the coffers of the top military contractors, a result of record Pentagon budgets and robust government spending on homeland security.
"This is a politically sensitive issue," said Byron Callan, an industry analyst at Merrill Lynch. "The companies have got to keep shareholders happy. But there is a political reality. If companies take this cash and give shareholders a big dividend, the Pentagon might say, 'Help us with that new fighter program.' " Of course, companies in many other industries are also enjoying a cash surplus. But what sets military companies apart is that they are either partly, or nearly fully, indebted to the government for their revenues. The large cash reserves, first reported in the industry publication, Aviation Week and Space Technology, pits two powerful interests against each other: Wall Street, which sees the money as a just reward for shareholder support and corporate risk-taking, and the Pentagon, whose spending has fueled the cash boom.
Shareholders in military companies, quite naturally, would like to see the money spent on bigger dividends and stock repurchases, which would make them richer and help push the stocks even higher. The Pentagon would rather see the companies spend more on basic military research and further acquisitions that would streamline the industry even more. "Returns to shareholders seem to be a red flag," said Richard Aboulafia, a military analyst with the Teal Group, an aerospace consulting firm in Fairfax, Va. "Acquisitions are more acceptable to the Pentagon as is spending the money on new product development. A lot will depend on the political winds." Also contributing to this cash buildup is the fact that at the urging of the Pentagon, the military industry underwent a wave of mergers over the last decade that reduced industry capacity and left the survivors more efficient. With fewer companies to share the growing Pentagon spending, each company has ended up with more. "Everyone sees all this cash generation," said Pierre Chao, a military analyst at the Center for Strategic and International Studies, a Washington nonprofit research group that studies military policy. "The political danger is that it attracts a lot of attention. Military contractors are getting to be efficient and this could punish them for being good at something."
At the moment, companies in many other industries are also flush with cash. At the top of the list is Exxon Mobil, which has $25 billion in cash on hand and is facing growing demands to spend some of that money on fatter dividends and more oil exploration.
In high technology, Microsoft has long had the biggest cash pile. Last year, it dipped into a $50 billion-plus cash account to give shareholders a one-time bonus of $3 a share, totaling $32 billion. But military companies are different. So tight are the ties between military contractors and the Pentagon that it is often difficult to determine where one ends and the other begins. And the cash surpluses come as the Pentagon must repeatedly go to Congress to pay for the war in Iraq as well as finance expensive weapon systems for the future. Already, some in Washington have taken notice - and responded. Senator John McCain, the Arizona Republican who has long clashed with both the Pentagon and the industry, recently pushed through changes in contracts for two major weapons systems, the $100 billion Future Combat System and the $4 billion C-130J cargo plane, to provide for greater oversight of industry profits. In addition, the high level of anticipated profit for a $23 billion aerial tanker lease program proposed by Boeing was one reason that deal was scuttled late last year. Michael W. Wynne, the acquisition chief for the Defense Department, said that while "we do not encourage companies to work for us below cost," he would like the Pentagon to benefit from some of the cash. "The only concern here, and it is a large one, is that the companies have an apparent negative view that investment within the defense sector for independent research and development on new products is not better than holding cash," Mr. Wynne said. Michael Goldberg, an industry analyst at Bain & Company, a consulting firm, estimated that the industry had $25 billion to $30 billion in cash reserves. He estimated that European military contractors, many doing business with the Pentagon, have another $15 billion to $20 billion.
In 1998, the Defense Department's procurement budget - the amount it spends on weapons -fell to $48 billion from $82 billion just six years earlier. Over the same period, a merger wave reduced the industry to a handful of big players.
Then, just as the mergers ended, the 9/11 terror attacks occurred, setting off a big rise in government spending for security, both military and civilian. At the same time, many mature weapons systems, like the F-16 fighter jet and C-17 cargo plane, were turning into cash cows. Also, expensive new weapons systems, which require tremendous start-up investments by the companies, were pushed further into the future, freeing up more cash today. On top of that, billions were spent on homeland security, much of it going to the major military contractors.
The Pentagon procurement budget for the current year is $78 billion. Lockheed Martin, the leading military contractor, whose revenues have risen by $11.5 billion since 2001 to reach $35.5 billion last year, has $2.7 billion in cash on hand. This compares with $455 million in cash at the end of 2000. In the last few years, the company has eliminated all its short-term debt, cut $5 billion from its long-term debt, repurchased its shares and increased its dividends.
Cash is building up so quickly at Lockheed that the company says it plans to return about half of its cash flow to shareholders as dividends or in the form of stock buybacks, which help increase the stock price. The brokerage firm Jefferies & Company, in a recent report, estimated that without this repurchase plan, Lockheed would have a cash balance of $4.9 billion by the end of 2006.
Despite the swelling accounts, Howard A. Rubel, an analyst at Jefferies, said it would be both unwise and risky for the Pentagon to reach for this cash. He said these companies were subject to the whims of Congress and the Pentagon, either of which could slash a military project as quickly as to finance one. "If I take the risk I deserve to be compensated for it," Mr. Rubel said. "The government wants to turn on them for doing a good job." Like Lockheed, Northrop Grumman, with $1.2 billion in cash on hand, has used its money to cut $4 billion from its debt. General Dynamics now has $1.1 billion in cash, up from $270 million in 2000. Boeing, the No. 2 Pentagon supplier, has about $6.5 billion in cash. While a big share of its business is building commercial airliners, the company recently reported a rise in anticipated revenue from its military division, to $32.5 billion. Profit margins on its military business exceeded 11 percent in the first quarter of 2005. James F. Albaugh, who leads Boeing's military business, said, "Our machine is running well."
Mr. Albaugh added that, over time, Boeing had been doing what it could to help the Pentagon, its largest customer by far, through cost reductions, especially on mature weapons systems. The current profitable situation, he said, contrasts with years of slim margins. "On every contract that we negotiate, our customer tries to drive costs down," Mr. Albaugh said. "If we perform well, we make good margins. If not, we don't."