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CONTINUING STRONG GROWTH FROM U.S. MAJORS

23 Apr 07. The FT reported that US defence companies are expected to report strong first-quarter profit this week, starting with Lockheed Martin today as the Pentagon budget scales new peaks and contract terms remain more favourable than most people can remember.

In recent weeks, though, a cloud has appeared on the horizon. High-profile problems on two large maritime projects, the US Navy’s $12bn Littoral Combat Ship (LCS) and the US Coast Guard’s $24bn Deepwater modernisation programme, have sparked speculation about whether the profitability of US defence contractors is under threat.

“In an otherwise very bullish outlook for defence spending,” says Lehman Brothers, the investment bank, “one of the potential weaknesses is sloppy performance leading to a backlash in the Pentagon and on the Hill.”

Defence contractors are still benefiting from lenient financial terms put in place at the end of the Cold War when a far bigger number of companies fought over a shrinking budget and the government’s aim was to allow the industry to survive.

At a recent lunch in London, Jim McNerney, chief executive at Boeing, the biggest military contractor after Lockheed, said: “There is always a need to strike a balance. You want to keep your defence contracting industry healthy…..I also appreciate the argument that says windfall returns should be looked at, though I have not heard such discussions myself.”

The immediate worry is a push by some in the Pentagon and Congress – including Ken Krieg, the chief Pentagon weapons buyer, and Republican senator John McCain – towards more fixed-price contracts on complex weapons development, shifting financial risk to contractors. Currently, the US government takes on almost all of the risk. The UK, the biggest Western weapons spender after the US, abandoned fixed-price contracts for new weapons recently after over-optimistic pricing led
to cost overruns that nearly killed off BAE Systems, the country’s dominant arms manufacturer.

US companies suffered a disastrous period of fixed-price contracting in the late 1980s, which was abandoned as the Cold War unwound.

“I think a sudden move back into fixed-price contracts would present issues for all US defence contractors,” Mr McNerney said. “But I don’t see that happening.”

Instead, the government will look at fixed pricing on a programme-by-programme basis as attempted on the LCS project, a $12bn programme to provide up to 60 vessels designed to fight close to enemy coastlines.

After large cost overruns on Lockheed’s first prototype LCS, the navy tried to force it to accept a fixed-price contract for a second ship.

Lockheed declined, a move welcomed by investors as showing the industry would not accept onerous contract terms. In fairness to Lockheed, which has built a reputation for project delivery, some of the LCS overruns were caused by the navy changing requirements.

This is another factor mitigating against fixed-price contracting, with responsibility for cost overruns often descending into a “blame game” between the contractor and customer. The $200bn Boeing-led Future Combat Systems (FCS) programme – to supply US combat troops with futuristic battlefield technology and sophisticated armoured vehicles – is another example of how costs can rise sharply even though the contractor appears to have met all price and schedule milestones.

Analysts at Sanford Bernstein estimate the programme’s price-tag has risen 79 per cent, even though Boeing has met its targets.

Such issues on the FCS project and on Deepwater, where the Coast Guard last week seized back management control from Lockheed and Northrop Grumman, have led to questions about the vogue for large defence contractors running big-ticket programmes.

RESULTS IN FULL

The Boeing Company

25 Apr 07. The Boeing Company’s [NYSE: BA] first-quarter net earnings increased 27 percent to $877m, or $1.13 per share (Table 1). Revenue grew 8 percent to $15.4bn and earn

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