Companies in the defense technologies ecosystem continue to closely monitor and optimize their labor force and supply chains while positioning for short- and long-term federal government modernization and innovation efforts. In third-quarter earnings calls, top industry executives primarily addressed supply chain disruptions, the federal contractor vaccine mandate, inflation and innovation.
Four key themes surfaced from the calls:
1. Supply chain murmurs from the previous quarter are now loud and clear
Shortages of electronic components are common, and lead times are growing. L3Harris Vice President and CEO Christopher Kubasik updated the company’s full-year guidance to account for the effects of global supply chain pressures and shortages of electronic components that he said “began adversely impacting our company at a time when our product is strong.”
Eric DeMarco, CEO of Kratos, similarly noted increasing lead times for critical parts from vendors. He lamented vendors canceling or significantly changing delivery schedules at the last minute. He also highlighted challenges associated with pandemic-related international quarantine and travel restrictions.
A primary challenge for BWX Technologies was getting technicians into the plant to help install equipment, CEO Rex Geveden said. As a result, the company doesn’t have the planned production capacity it expected to have at this point in the year.
Lockheed Martin Acting Chief Financial Officer John Mollard estimated the company would require 12 to 18 months to incrementally recover from “supply chain impacts” that were greater than anticipated and spanned multiple suppliers.
2. Vaccine mandate compliance is underway
Federal contractors appreciate and acknowledge the necessity of complying with the Biden administration’s executive order requiring federal contractors to be vaccinated against COVID-19. General Dynamics CEO Phebe Novakovic emphasized that the aerospace defense world has “a history of dealing with challenges methodically, systematically, and thoroughly,” suggesting they will handle the vaccine mandate in a consistent fashion.
Executives are signaling most of their workforces are vaccinated, but there could be disruptions associated with a small fraction not in compliance. Mercury Systems CEO Mark Aslett said the mandate “should enhance the resiliency of the business by protecting our employees and strengthening our ability to delivery on our commitments,” but he also noted that it may result in higher employee turnover and operational impacts in the short term. Kratos’ DeMarco cited employee distraction, unrest, some retirements and resignations because of the company’s vaccine mandate compliance efforts.
Many also acknowledge the positive impact to company operations and sales because of higher U.S. vaccination rates, the goal of the executive order. Raytheon CFO Neil Mitchill noted the potential near-term pressures to the supply chain but said he was encouraged by higher vaccination rates continuing to “build confidence in the safety of air travel going forward.”
It is important to note that most of these third quarter earnings calls took place prior to the vaccine mandate deadline being extended from Dec. 8 to Jan. 4.
3. Pricing and inflation—a mixed bag
Mentions of inflation and price increases were common but diverse. Some companies are not affected at all; some are able to pass along price increases; others are protected by long-term supplier agreements, and others are struggling with profitability on fixed-price contracts because of input price increases.
Raytheon CEO Gregory Hayes said inflation has not made a noteworthy impact on the company, due to long-term supply agreements in place that cover a vast majority of its materials. He said that an extended period of inflation would primarily result in the company passing the increased costs on to the government customer.
Aslett of Mercury Systems referenced substantial increases in lead times and price inflation. He applauded his team for handling it well and signaled his belief that the inflationary environment and risk associated with revenue will be “around for quite some time.” In response, his team made additional raw material purchase commitments to cover the second half of the year.
DeMarco of Kratos noted price increases in certain areas, specifically target and tactical drones. The company has tried to pass along price increases when able but has a variety of firm fixed-price contracts with firm fixed-price options that provide little flexibility.
4. Leading with innovation
Defense technologies continue to challenge the status quo and revolutionize defense, warfighting and security. Executives see opportunities relating to hypersonics, artificial intelligence, machine learning and the metaverse.
L3Harris’ Kubasik said the company continues to integrate its businesses while redesigning factory layouts, integrating automation tools, and using augmented reality to display and validate processes. He also noted investment in a risk dashboard that uses publicly available data around weather, wildfires and suppliers’ financial stability to gain greater supply chain visibility.
Maxar CEO Daniel Jablonsky took the innovation chatter even further by discussing the gaming, simulation and metaverse applications of high-accuracy data.
DeMarco of Kratos highlighted an all-too-common issue of living on the cutting edge: the Department of Defense’s so-called Valley of Death. That term refers to the two-year period between receiving funding to develop a product and it becoming part of a program of record.
Kratos is in the Valley of Death with several of its tactical drones. “We are doing everything we can with the DOD customer set, the Pentagon customer set and congressionally,” DeMarco said, “to encourage them … to move faster than the existing military DOD bureaucracy and infrastructure allows them to do.”
Defense procurement practices and policy must evolve to support innovation and development in a rapidly changing world and threat environment.
Company executives in the sector remain agile, anticipating future government spending trends and investing in rapidly advancing technologies. We expect fourth-quarter earnings calls to touch on continued supply chain monitoring, the 2022 National Defense Authorization Act, and continued developments around broader labor and pricing issues facing the macroeconomy.