Defense Industry Crying Wolf on Its Finances

For the first time since 1985, the Department of Defense (DOD) has comprehensively reviewed how it finances military contracts. The Office of the Under Secretary for Acquisition and Sustainment, Defense Pricing and Contracting released a study last month detailing the impacts of its contract finance and profit policies on the financial health of the defense industry.

The study confirms the obvious: Military contractors are doing quite well in the aggregate. It also reveals financial data that contradicts industry statements about its financial inability to invest in innovation.

Defense companies are grossly mischaracterizing their financial well-being and pushing Congress to grant them even more taxpayer dollars — all in the name of competing with China and supporting Ukraine. But the data indicates that defense companies are more focused on enriching their shareholders than on investing in their businesses to meet national security challenges.

Indeed, the DOD study found that “Despite improving profit margins and cash generation for defense contractors in 2010-2019 vs 2000-2009, the share of contractor spending on Independent Research and Development (IR&D) and capital expenditures declined while cash paid to shareholders in dividends and share repurchases increased by 73%.”

Still, defense companies are claiming they can’t make the investments necessary to meet the current national security moment — one dominated by near peer competition. Contractors have named inflation, delayed congressional spending bills, and insufficient defense spending in general as inhibitors of a strengthened industrial base. When commenting on the study, trade associations claimed that the health of the defense industrial base is “fair to poor” and “failing.” One group said that for the most part, profitability is “insufficient to finance the investments” needed to innovate and ramp up production capacity. Industry commentators doubled down on the alleged inability to finance investments by claiming they have to seek out private financing to conduct internal research and development for government applications, calling the associated costs “ultimately unrecoverable expenditures.”

But that’s not true.

Research and development costs are largely reimbursable expenditures. And the Pentagon pointed that out in the study, writing that the comment was “rather misleading” given that the government covers such costs when companies with cost-type and fixed-price contracts claim them through relevant reimbursement requests to the Pentagon. Not only that, but the DOD study highlights that research and development investment “generates revenue, profits and cash” for defense contractors. So the government invests taxpayer dollars and companies reap the financial benefits.

That is a great deal for defense contractors!

The government reimburses companies for their independent research and development investments, improving revenue, profit, and cash flow — which theoretically increases companies’ ability to invest in their growth. One defense industry association affirmed this logic in its public comment on the DOD study, explaining that “a company that has strong cash flow … might be in the position to pursue increased innovation through more significant investment in internal R&D activities.” It’s notable, then, that cash flow increased for the top 10 contractors and for the rest of the industry over the twenty years covered by the study. To put this growth in context, researchers calculated free cash flow — the cash available for a company to spend however it wants — as a portion of industry revenues, and found an approximate 1.1% increase in cash flow as a portion of revenue for the top 10 contractors, and about a 3.1% increase for the rest of the industry.

Yet, according to the study, there was a steady decline in industry-wide investments in research and development, a trend that was “surprising” and “perplexing” to the DOD. Researchers found that, of the industry cash available for internal IR&D investment from 2000 to 2019, the actual IR&D spending by the top 10 contractors declined from about 52% to 33%. The rest of the industry spent even less of its available IR&D cash, reducing spending from about 53% to 25% in the same time period.

The defense industry didn’t just drastically increase money paid to shareholders because it’s doing well — it did so at the expense of internal investment, and therefore, taxpayers. The DOD study found that when contractors generated additional profits and cash over the twenty-year study period, they chose to significantly increase cash dividends and share repurchases to shareholders, “thereby reducing the amount of invested capital for the corporation.” This is true for the top 10 contractors as well as for the rest of the industry, although the study notes that the top 10 contractors actually disbursed $17 billion more to shareholders than they generated in cash flow from 2010 through 2019, the latter half of the study period. Still, taxpayers are expected to pick up the tab on investments for the defense industry.

Defense companies deliver their shareholders excessive financial returns at a great opportunity cost. In addition to reduced IR&D spending, capital investment takes a hit. Companies stuff the pockets of their shareholders today rather than investing in the equipment they need for tomorrow.

Improved cash flow should encourage contractors to make capital investments right now. But even in the longer term, the government covers all depreciation costs of capital assets on defense contracts. For more specialized equipment, the government reimburses all costs incurred if the equipment has a useful life of more than one year, so long as the contractor can demonstrate that the equipment “can only be used in support of the end-item being procured” by the government. In other words, the government spends a lot of hard-earned taxpayer money on IR&D and capital assets for contractors.

The defense industry therefore enjoys asset and shareholder returns well beyond those of their peers in the commercial sector. Yet they continue to whine about lower operating profit margins. The DOD calls the industry out for this on several occasions in the study, pushing back on contractor arguments that they need better revenue, profit, and cash flows to invest in the IR&D and capital assets needed to meet pressing national security challenges.

The data doesn’t lie. The defense industry outperforms commercial counterparts in eight out of nine key financial metrics of corporate success, in large part because the defense industry receives preferential governmental treatment due to the national security matters underpinning so much of defense production. Defense companies likewise outpace commercial peers when it comes to keeping their shareholders happy, with higher total returns to shareholders than even those companies included in the S&P 500.

It’s clear now how companies finagle such high returns. It is even more egregious when you consider the litany of abject weapons systems failures over the past 20 years. Lawmakers should not come running the next time the defense industry cries wolf on its finances.