Defense technology executives are pleased with increasing demand from customers. However, supply chain and labor challenges continue to cause pain. These challenges are increasing the cost of doing business and pressuring profit margins. Many companies have successfully implemented operational improvements and cost-cutting strategies as countermeasures, reaping the benefits of their efforts.
Four themes emerged from the Q3 earnings calls, transcripts of which were provided by Bloomberg.
Customer demand is stronger than ever
Executives reminded investors that demand continues to increase and diversify. Kathy Warden, who serves as chair, CEO and president of Northrop Grumman Corporation, signaled the expectation of an increased defense budget, accounting for both inflation and the requirements of strengthening the country’s defense posture. The current FY 2023 Department of Defense budget request is $773 billion, which is a 4.1% or $30.7 billion increase from the FY 2022 budget.
Warden said that she does not expect global demand to have a material impact on Northrup Grumman revenue for another 18 months, and added that now is the time to advise and share insights on how the company can address international customers’ highest priorities to be well positioned for 2024.
Other executives—including Robert Mehrabian, CEO of Teledyne Technologies, Inc.; and Rex Geveden, CEO of BWX Technologies, Inc.—were more specific about some of their products, saying that the demand for electronic components and nuclear power solutions, are strong.
From a customer-diversification perspective, nearly all the executives highlighted increasing global demand, specifically from ally countries. Gregory J. Hayes, chairman and CEO of Raytheon Technologies Corporation, mentioned that Switzerland will be modernizing its air force by signing a $6 billion contract to acquire 36 F-35 jets.
Parts and labor remain a challenge
Many defense technology executives agree that there has been a modest improvement in supply chains. But Phebe N. Novakovic, CEO of General Dynamics Corporation, said businesses keep experiencing challenges, ranging from disruption to inflation to labor availability.
Some companies have addressed the scarcity of parts through acquisitions.
Mehrabian gave the example of Teledyne Technologies’ traveling wave tubes. The tubes require a power supply, and there is a scarcity of suppliers in that domain. The company vertically integrated through acquisition and controls its system of tubes and power supplies.
Other companies have accepted the market’s new lead times as part of their inventory planning process.
Christopher Kubasik, CEO of L3Harris Technologies, Inc., said, “In the old days, you did just-in-time inventory, and that doesn’t work anymore. Lead times … are going out 18 months versus 18 days.” Kubasik said companies that are agile enough to adjust and accept the new realities will benefit from their efforts.
In terms of labor, most defense technology executives agree that finding and retaining skilled talent remains a challenge.
“We are tracking almost 10% below our net headcount plan,” Geveden said. “We are simply struggling to sufficiently hire to satisfy our growth needs, as we stretch to meet demand from our customers.”
Hayes said Raytheon is leveraging contract labor agreements to help bridge the gap in labor shortage. Warden said Northrop Grumman has opened up the pool of candidates by recruiting less-skilled workers and accelerating their technical growth by establishing a training facility.
Defending margins part I: Operational transformation
Many defense technology executives are preserving the value of their companies by redesigning established operational processes.
Geveden said BWX Technologies is taking a fresh look and improving the business by getting back to basics. The company is deploying lean manufacturing tools—including visual flow boards, process mapping and key performance indicators—and standardizing their use across the enterprise.
Mark Aslett, president, CEO and director of Mercury Systems, Inc., said the company is transforming its procurement organization by centralizing the function and taking advantage of scale. Mercury also implemented an artificial intelligence and machine-learning-based procurement tool to complement the centralization of the procurement function. Mercury leaning into technology is a timely reminder that innovation solves challenging problems and is a critical tool in any executive’s toolbelt.
Defending margins part II: Cutting costs
As wages and component prices continue to increase, defense technology companies face constant pressure to protect and defend their profit margins. Cost cutting and optimization are levers that many companies are pulling to address inflation and supply chain disruptions.
Novakovic said General Dynamics has cut costs and restructured parts of the business to offset the margin and earnings impact of revenue delays. Kubasik said that higher input costs—whether through supply chain, labor or inflation—and operational challenges, such as redesigning parts to meet customers’ critical missions, has equated to about $250 million in incremental costs in 2022 for L3Harris. The company has successfully offset about 70% of the $250 million increase across the business.
These four themes are summarized in the illustration below:
The takeaway
Industry executives are confident in the growth and diversification of customer demand. Strained supply chains are still the biggest challenge to meet growing demand. Wages, component price increases and inflation threaten profit margins. Industry executives are defending those margins through operational transformation and cost optimization.
We expect next quarter’s earnings calls to continue focusing on strategies to combat rising prices and perspectives around the FY 2023 defense budget.
