The aerospace and defense (A&D) sector, which has long been a Wall Street darling, is facing a crossroads. For the last five years, the A&D Index has delivered an average annual total shareholder return (TSR) of 25.8 percent, handily outperforming the S&P 500’s TSR of 15.6 percent. But at a certain level, these returns are less impressive than meets the eye. According to our analysis, these returns have come less from exceptional performance than from higher expectations for the future. Indeed, it’s clear that investors are pricing in steady increases in cash flows and returns in companies’ current record-high valuations. By our calculations, such expectations have accounted for about two-thirds of the sector’s returns in the last several years. And between 2017 and 2021, investors expect A&D companies to roughly double their growth rate and to continue expanding their EBITDA margins at much the same rate.
The higher expectations can be partially attributed to an anticipated increase in defense spending and expectations for future lower corporate tax rates. But these macro trends alone won’t deliver the anticipated level of performance improvement. To meet, let alone exceed, these great expectations, A&D companies will need to accelerate profitable growth.
But as is so often the case, the past is not necessarily a guide to future performance or strategy. In fact, the imperative to deliver shareholder value through improved operational performance and increased earnings will place pressure on A&D companies to change the way they’ve deployed cash in recent years.
For some time now, the A&D sector has opted to return capital to shareholders via share buybacks and dividend payouts, rather than to increase capital investment in research and development. Put another way, the industry has been spending more on buybacks and dividends than it has on R&D.
This capital deployment strategy makes sense in the context of a challenging and uncertain defense environment. Over the last several years, the U.S. government has started few new significant weapons programs, and few such initiatives are on the horizon. Military budgets have been under constant pressure, and it remains unclear how quickly or dramatically that might change in the face of continuing fiscal constraints. And given the evolving global threat environment and the Pentagon’s shifting spending priorities, a sort of paralysis has set in. As one might expect, A&D companies have been taking a conservative approach, possibly jeopardizing the growth and innovation needed for the U.S. military to maintain a technological advantage. The recently passed corporate tax reduction in the U.S. would provide A&D companies the opportunity to change this by increasing investment in growth and innovation.
But A&D companies will not be able to fulfill the expectations of markets — or of their chief client — by remaining risk-averse. The legacy industrial base faces disruption both from commercial technology entrants that can innovate more rapidly and from U.S. adversaries that are gradually eroding the technology edge the country has historically enjoyed.
Client expectations are changing, too. In the past, the Department of Defense (DoD) typically funded research and development, specified the weaponry it needed, and worked closely with contractors on developing product specifications. But today the DoD is seeking partners, be they legacy players or nontraditional entrants, that can invest in new technology solutions and deliver them faster and cheaper.
The resulting pressures mean A&D companies will have to change how they use their capital and develop new products. Instead of relying on annual planning cycles to create financial forecasts, the industry will have to adopt a more rigorous approach to evaluating and making strategic investment choices that yield long-term value (e.g., product development, tech innovation, and R&D). And it will have to avoid relying on overvalued acquisitions to compensate for the lack of organic innovation and growth. A&D companies should strive to develop coherent strategies shaped by a culture of risk taking and innovation.
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