Defense technology companies continue to face headwinds due to inflationary pressures, increased interest rates and supply chain disruptions. But demand is increasing due to geopolitical risks and national security concerns. During third-quarter earnings calls, defense tech executives highlighted their approach to balancing risk through financing decisions, inventory investments and flexible development contracting vehicles.
Three themes emerged from the earnings call transcripts and 10-Q filings, both of which were provided by Bloomberg:
The market effect of rising interest rates
Executives highlighted their exposure to market risk related to increased interest rates. Many companies, such as Lockheed Martin (LMT), used interest rate swap agreements to mitigate the exposure of future interest rate movements. In its 10-Q filings, LMT said it hedged cash flow risk by entering into “fixed interest rate swaps, effectively converting variable rate borrowings to fixed-rate borrowings in order to minimize their impact of interest rate changes on earnings.”
Defense companies are looking to grow value through increased sales and cost optimization efforts as the cost of external debt is high due to interest rates.
Northrop Grumman (NOC) and LMT executives also referred to the reduced buying power of the U.S. government, due to the increased cost of borrowing. While the government has increased investment in national security, interest rates may affect U.S. and allied countries’ spending priorities due to constrained purchasing power.
Supply chain turbulence
Defense technology companies continue to grapple with ongoing supply chain challenges, affecting their ability to meet program objectives and negatively affecting operating cash flow. Defense companies highlighted the risk of increased lead time, parts shortages, logistic delays and supplier price increases. The industry is striving to manage supply chain disruptions as demand grows due to geopolitical risks.
NOC’s 10-Q filings said: “The conflict in Ukraine has increased global tensions and instability, highlighted threats and increased global demand, as well as further disrupted global supply chains and added costs.”
Teledyne Technologies’ 10-Q filings said the company has “experienced supply chain challenges, including lead times, as well as cost inflation for parts and components, logistics and labor due to availability constraints and high demand.”
Defense companies are moving away from just-in-time inventory to just-in-case inventory, building up certainty stock and shoring up lower-tier suppliers to meet growing demand.
Chris Kubasik, CEO of L3Harris Technologies (LHX), noted the importance of investing in sub-tier suppliers to support defense readiness.
Defense technology companies discussed the increasing risks of fixed-price development contracts. Greg Hayes, CEO of RTX Corp., said, “We’ve had a handful of challenging fixed-price development contracts that have been a bit of a drag.”
Fixed-priced development contracts have an inherent risk of unforeseen complexities, evolving contract requirements and cost overruns. These are difficult to manage in normal market conditions, but market headwinds such as inflation, interest rate increases and supply chain disruptions have made them unsustainable.
Kubasik said LHX will no longer bid on fixed-price development contracts. He said, “Everyone in the industry will stop bidding, and we’ll get the right vehicle, and we’ll fight it out for the best solution.”
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Defense technology companies are no longer willing to sacrifice profit margins for top-line growth. “The best way to get your margins up is to stop writing off money on programs,” Kubasik said.
If more defense technology companies stop bidding on fixed-price development contracts, the government will use other contracting vehicles to balance the risk and encourage defense research and development.
Defense technology businesses are navigating a complex landscape shaped by escalating interest rates, persistent supply chain disruptions and a growing reluctance to embrace fixed-price development contracts. They are seeking to balance risk, ensure financial stability, build supply chain resilience and increase contractual flexibility as market demand increases.
Jenn Randles and Zach Phillips contributed to this article.