Recent comments by U.S. Navy Secretary Carlos del Toro have reignited a long-running issue of contention between Department of Defense officials and the management of the largest publicly traded defense prime contractors — stock buybacks. Specifically, some senior DOD officials have raised concerns when companies that are doing business with the DOD use remaining capital to buy back existing shares of company stock in lieu of additional investments in research and development, or production capacity.

The secretary is rightly focused on the need for increased investment to facilitate greater innovation and production capacity for strategic competition with China. The management teams of some large defense primes, on the other hand, buy back shares as an efficient way to return value to shareholders after considering the attractiveness of investment opportunities available to the company.

Changing this situation and spurring increased investment in the defense market requires addressing the incentive structures that guide market behavior, including stock buybacks.

Before examining market incentives, it is worth noting that the U.S. government decided many decades ago to largely privatize the defense-industrial base. While the DOD retains a modest number of government-owned arsenals, shipyards and depots, the vast majority of the systems developed and services conducted for the DOD are performed by for-profit companies. These companies have developed the innovations and capabilities that have made U.S. forces the best in the world.

This industrial base includes approximately 200,000 small, medium and large companies, the vast majority of which are privately held. Including those traded on foreign exchanges, there are only about 100 companies that are publicly traded. And only a very small fraction of those companies use share buybacks consistently as a strategic management tool.

Secretary del Toro captures the essence of the anti-buyback argument, which has been articulated by Pentagon leaders for years: “You can’t be asking the American taxpayer to make even greater public investments while you continue, in some cases, to goose your stock prices through stock buybacks, deferring promised capital investments, and other accounting maneuvers.”

Why do defense companies continue to pursue stock buybacks? It is principally the large mature defense primes such as Lockheed Martin, Northrop Grumman and HII that buy back stock. These firms are profitable, generate significant cash flow, have a relatively low cost of capital and are not highly leveraged.

Lack of capital is not a problem hindering investment at the largest defense primes. The issue revolves around the capital allocation decision. If large defense primes are not making significant investments, it is because they believe that this incremental dollar is unlikely to materialize into a profitable contract in the future. For that to change, these primes need to see a better return for the earnings they intend to retain and reinvest. Those returns could come through an increased number of growth opportunities, a greater frequency and volume of competitions, or margin improvement.

In contrast to the large mature primes, smaller publicly traded companies such as AeroVironment and Kratos do not typically buy back shares. They are instead investing in growth, as they see significant opportunities in their own market segments and beyond as the DOD spends heavily in unmanned systems, advanced electronics, autonomy and other areas central to the National Defense Strategy. If similar, larger incentives existed for the larger primes, then that is where capital would be allocated.

Bigger budgets obviously help incentivize investment, but changing how the DOD buys through practices such as open architectures, multiyear contracts and multiple production lines will likewise create more contract opportunities and therefore that stronger demand signal that industry needs to invest.

The DOD is heading in that direction in several important ways, and more emphasis there would be productive. Adopting some of the recent recommendations of the congressional commission on defense planning, programming, budgeting and execution reform, for example, could substantially contribute toward improving incentive structures.

Another promising avenue the DOD can use to incentivize investment by the larger primes revolves around program performance. Secretary del Toro has justly emphasized in his recent remarks that “industry must deliver platforms and capabilities on time and on budget for the sake of our warfighters who are in harm’s way.”

How about, for example, rewarding contractors with substantial profit-margin expansion opportunities for delivering ahead of terms, and punishing them more severely for missing the mark? The beauty of a commercially viable defense industry is that its participants are responsive to incentives.

Ultimately, management at for-profit companies are stewards of others’ capital. Browbeating the financial practices of industry alienates firms large and small. Let’s work instead to change some of the incentive structures in the defense market. Addressing these will help foster the innovation and investment we need in our industrial base as well as reducing stock buybacks along the way. And it is ultimately that vibrant public-private partnership we need to confront today’s daunting national security challenges.

Jerry McGinn is the executive director of the Greg and Camille Baroni Center for Government Contracting at George Mason University and a former senior U.S. Defense Department acquisition official. Mikhail Grinberg is a partner at Renaissance Strategic Advisors and a member of the center’s advisory board. Lloyd Everhart is a research manager at the center.

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• Source: https://www.defensenews.com/opinion/2024/04/08/stock-buybacks-in-defense-what-drives-them-and-how-that-can-change/