Defense technology companies are positioning themselves to capitalize on the anticipated passage of a proposed tax relief bill related to research and development (R&D). Companies also seek to balance contracting risk by selectively bidding on requests for proposals (RFPs) and shifting the industry toward value-added pricing strategies.
Two themes emerged from the earnings calls, transcripts of which were provided by Bloomberg.
Accelerating innovation
Defense companies have been lobbying for the immediate expensing of R&D costs to be restored. These costs fall under section 174 of the Tax Cuts and Jobs Act, which was enacted in 2017.
Executives from Mercury Systems Inc., Northrop Grumman Corp., and RTX Corp. highlighted opportunities for their companies if the Tax Relief for American Families and Workers Act of 2024, H.R. 7024, becomes law. The bill is before the Senate.
Currently, defense technology companies must amortize their domestic R&D expense over five years. The tax relief bill would potentially allow companies to deduct R&D expenses in the year incurred, improving cash flow and liquidity.
To find out more about this topic, visit RSM’s Section 174 Resource Center.
Dave Farnsworth, CFO of Mercury Systems, said he anticipates his company will receive $40 million in additional cash flow in fiscal year 2024 if the bill passes.
Kathy Warden, CEO of Northrop Grumman, said, “When we take these factors, sustainable top-line growth with expanding margins, and couple those with declining capital intensity and lower projected cash taxes, you get a recipe for robust cash flow growth for years to come.”
In addition to increased cash flow, the restored tax treatment could foster innovation, multiple executives said. Companies may invest in R&D projects if they can realize tax benefits sooner. The increased innovation could lead to market growth and job creation as companies develop new technologies and products.
Balancing risk and reward
Defense technology executives highlighted a shift from must-win programs to bidding only on balanced price risk contracts.
Jim Taiclet, CEO of Lockheed Martin Corp., said that because the defense industry primarily has one customer, contractors have been willing to take on significant cost, price and technical risk to get the must-win program.
Taiclet of Lockheed and Warden of Northrop both said they will bid only on RFPs that have balanced price risk profiles. These leaders are willing to pass on near-term wins to shift the industry away from a cost focus to a capability focus, which is a strategic approach that prioritizes features, functions and performance that are most valuable to the U.S. government. It involves aligning product development with customer needs and market demands.
Multiple executives referred to increasing their companies’ prices to mitigate anticipated cost escalation, changes in market demand and margin erosion. Defense technology companies may be looking to differentiate themselves by increasing their pricing to reflect the perceived value of their products and services.
As the industry moves toward a capability focus, defense companies will need to evaluate their pricing strategy.
Taiclet anticipates a shift to value-added pricing or subscription pricing similar to the commercial tech industry. Value-added pricing is based on the unique benefits and advantages a product provides and is customer-centric. Defense technology companies are seeking partnerships with commercial tech companies, which do not participate in the defense industry due to Federal Acquisition Regulation requirements to disclose cost information.
Defense technology companies are continuing to oppose the unbalanced risk of fixed-price development contracting, moving beyond traditional cost-type contracts and seeking new regulations that allow value-added pricing models to better align with the evolving demands of the market.
The takeaway
Defense technology companies are focusing on enhancing their financial stability, accelerating innovation and driving growth while balancing risk. The anticipated passage of the tax relief bill related to R&D would improve defense technology companies’ cash flow, foster innovation and lead to overall market growth. Defense technology executives are also seeking to reduce cost and pricing risk, while attempting to influence the industry to embrace value-added pricing models similar to commercial technology companies.
Jenn Randles contributed to this article.
