Opinion: The Importance Of The U.S. Defense Industry’s Other Partner

U.S. military and civilian leaders often speak of “our industry partners,” glossing over the fact that defense contractors also have other partners. Some of the most important of these are shareholders, although employees, suppliers and communities also have interests and are partners in a company’s performance.

Government customers may believe that since they are paying contractors for products and services, they have the right to decide what those contractors do with the cash flow and profits they receive from the Pentagon. When the vast majority of free cash flow generated by large public companies is turned over to shareholders in the form of dividends and stock buybacks, it can stoke tension and resentment, particularly when the Defense Department faces its own budgetary pressures and when contractors are reticent to take risks through research and development and capital investment.

However, the Pentagon and Congress must keep in mind shareholder partners’ influence on public company management and recognize that the shareholder partners’ motives might affect defense acquisition outcomes.

Shareholders are overwhelmingly institutional investors, which now own 64-100% of the shares outstanding in the larger U.S. defense companies. These investors represent a mix of active and passively managed funds, each of which may have billions of dollars to allocate. That money is provided to them by individuals investing in mutual funds or exchange-traded funds, or by corporations and governments for pension and retirement funds. Institutional investors typically invest across asset classes—they own equity (stocks), debt and other alternative investments. They typically invest globally and across all different market sectors, and their goal is to earn positive returns on invested capital. 

Shareholders can influence management by buying and selling stock and through the company’s board of directors. Shareholders of public companies vote annually on who serves on the board of directors of companies they own based on their stock holdings. In the overwhelming majority of “proxy” votes, institutional investors support the directors up for election or reelection. 

Corporate boards of major contractors are diverse and largely have nondefense backgrounds. Boards are elected by shareholders, and they are expected to exercise oversight and help shape strategic direction and capital allocation—how cash flow is used and other financing decisions. 

Military officials and civilian leadership in the Pentagon, as well as members of Congress and their staff, must recognize that boards of major defense companies are not comprised solely of retired military officers or former senior Pentagon leaders. Board members, typically drawn from nondefense corporate backgrounds, are likely to look at the same metrics to build shareholder value as for nondefense companies—notably sales growth, profit-margin improvements and free cash flow generation.

Institutional investors are far more likely to sell their equity holdings if they are unhappy with how a company is performing. However, “activist” investors can buy enough shares to force proxy battles by seeking election of a board more aligned with their own interests that can force out current management. These sorts of fights usually occur when investors perceive a company to be undervalued and seek actions to realize value.

The Pentagon and Congress may not ultimately care about activist investors, but senior management generally does not want to see its plans and careers shredded by new owners who promise to deliver better value for shareholders. Management will thus strive to ensure that the company is fairly valued, lest they invite unwanted and disruptive attention.

Management of public companies is assessed on how the stock performs against peers and broader market indices. Some charts in SEC 10-K filings show this annually. Institutional investors also are looking across market sectors and, in some cases, multiple asset classes. Defense contractor leaders are judged not only by how they perform against their peers but also by how they compare with broader subsectors and entire market indices. Equity is a key part of senior management compensation as well, and so there is a direct interest in seeing how the company’s stock performs.

Public companies often buy back their stock because institutional investors want them to do so. Public defense companies are not unique in their use of free cash flow for buybacks. Share repurchases may be seen as a more attractive use of cash flow that is less risky than a major diversification effort, building new capacity that the Pentagon may not utilize or investing in research and development that may not yield profitable products and services. Buybacks are likely to persist unless more attractive uses of cash can be found or companies see competitive threats that compel other uses.