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.
A&D companies will not be able to fulfill the expectations of markets — or of their chief client — by remaining risk averse.
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.
Assuming Greater Risk
Principally, the A&D sector will have to generate demand for new requirements by becoming more innovative in developing technology solutions. Working this way involves accepting uncertainty — usually by making bets and taking risks. Although commercial companies do this routinely, it represents a different mind-set for many defense companies. Some, though, have begun to adapt. Rather than waiting for the Pentagon to fund programs, these legacy players have embraced uncertainty by self-investing in new systems, upgrading older ones, or investing indirectly through ventures. At the same time, new privately funded entrants are making major inroads. Some notable examples are below.
• Sierra Nevada Corporation, in partnership with Embraer Defense & Security, built the combat-proven A-29 as part of the U.S. Air Force’s Capability Assessment of Non-Developmental Light Attack Platforms. The Air Force, in an effort to address a growing operations and sustainment challenge, wanted to determine whether it should procure light-attack fighters with minimal development work through the OA-X program. Used by other air forces worldwide, the A-29 is a durable and versatile turboprop aircraft capable of carrying out a wide range of fighter, intelligence, surveillance, and reconnaissance missions.
• Boeing Defense, Space & Security, in partnership with Saab Group, broke the norm by investing its own resources to build a production aircraft that provides the U.S. Air Force with a new, advanced pilot training system. The aircraft was developed as a possible replacement for the T-38 as an entry in the Air Force’s T-X advanced training system program.
• Companies such as Lockheed Martin (LM) have taken a different path by focusing long-term, strategic investments on technology innovation in order to drive growth in existing and new markets through venture funds. LM’s fund invests in early-stage technology companies that are involved in autonomous systems and robotics, cybersecurity, artificial intelligence, advanced electronics, and sensor technologies.
Privately funded companies have also made significant gains in the domains of legacy contractors. In the space sector, for example, SpaceX is continuing to develop a reusable launch system that can carry military and commercial payloads into space.
A Way Forward
A&D companies, like those in all other industries, confront the constant challenge of determining how to effectively allocate capital in a way that will build differentiating capabilities, help them innovate, and maximize shareholder returns. How can they best develop an investment strategy to meet these goals? A good starting point is to adopt a more disciplined approach to valuing strategic options in order to maximize the company’s potential for growth. This begins with predicting the free cash flows or intrinsic value that will be generated from the company’s current strategy and other strategic options. Leaders must recognize the key drivers of intrinsic value in generating profitable returns on capital, not simply returning capital to shareholders. A&D companies should ensure that their approach to strategic investment decisions incorporates the following elements.
• Well-defined criteria for achieving success, starting with understanding shareholder value creation expectations and what drives intrinsic value
• A disciplined approach to managing capital investments as a portfolio of options based on returns
• An understanding of value creation patterns linked to specific assets and core capabilities that provide the sources of a company’s competitive advantage
• Incentive and reward structures and performance management programs that hold leaders accountable for their incremental value-creation impact
• Agility in the face of market uncertainty through a dynamic strategy process that is not constrained by annual financial planning cycles
• A dynamic valuation approach to assessing strategic options and trade-offs (e.g., decision-tree analysis, what-if scenarios, and real option value analysis of alternatives in uncertain environments)
• Strategic spending that serves as the centerpiece of what we call a fit for growth program, in which unnecessary expenses are reduced by ruthlessly focusing on the right markets, business portfolio, and technology to create capacity to invest in the company’s future revenue and profit streams
If A&D companies are to exceed investors’ expectations, these elements should become the rule rather the exception.
A dynamic assessment of a company’s value performance and prospects will (1) help companies decide when it is best to invest versus returning cash to shareholders, (2) improve the outcomes of its strategies, (3) increase intrinsic value, and (4) drive its share price even higher.
- Larry Jones is a principal with PwC US in the valuation practice. Based in Chicago, he works with senior corporate and business unit managers to establish the conditions needed to deliver superior performance.
- Randy Starr is an advisor to executives in the aerospace and defense industry for Strategy&, PwC’s strategy consulting business. He is a principal with PwC US, based in Florham Park, N.J., and directs the aerospace and defense practice.