Defense contracting executives insist companies will be able to retain boost from tax legislation

By Marjorie Censer / February 9, 2018

The new tax legislation passed late last year has been hailed by many business executives, who argue the changes will help them invest in their workers and new technology.

But the Wall Street analysts who focus on defense companies have increasingly expressed concern that contractors will not reap the expected benefits because they will face pressure -- both from the government and in the competitive marketplace -- to lower their prices, rather than hang on to higher profits.

In discussions with analysts in recent weeks, many defense executives have shot down this idea, arguing that tax legislation is not meant to simply reduce prices.

In a call late last month, for instance, Marillyn Hewson, the chief executive of Lockheed Martin, told investors tax reform was simply not intended to operate that way. Based on her involvement in the process, she said, the government’s expectation is that companies will invest in jobs.

"Our vision is to use these benefits to differentiate ourselves in the global marketplace through investments," she said. "If we don’t do this, I think we would have wasted the incredible potential that tax reform presents to us."

"I just take you back to the point of why the tax reform was put in place," Hewson added. "It was to invest in America to create jobs and accelerate economic growth."

Indeed, the government has not signaled it expects to claw back a portion of tax cuts through lower prices. Ellen Lord, the Pentagon's top weapons buyer, told reporters last month she's "not focused on tax cuts."

Asked whether she expects tax legislation to provide a way to reduce costs, Lord said the Pentagon is "working very closely with contractors to set expectations for fidelity around the cost basis of each program."

Rather than focusing on tax cuts, she said, her energy is being spent on creating a data-driven process and boosting competition.

Wes Bush, Northrop Grumman's CEO, said during a call with analysts in late January the government’s reaction will drive industry's actions.

Tax legislation is "a strong motivator for the increased capital investments that we're making and our ability to continue strong [research and development] investments," he said. "Should there be a view that regulations ought to change to take some of that benefit away, I think it would be self-defeating for our customer community because it ultimately would discourage us from investing on their behalf, it would discourage us from the type of things that we need to be doing to support their capacity and technology needs for the long term."

Analysts have also posited the benefits for shareholders generated by the tax legislation could disappear even without government intervention if contractors end up competing more fiercely on price. But executives have said they don’t expect tax changes to remake procurements.

Larry Prior, CSRA’s chief executive, said during an earnings call this week he expects the majority of tax reform savings to "fall to the bottom line."

"We'll stay sensitive to competitive forces in the marketplace, but we do not expect this benefit to be competed away," he said.

Prior said CSRA will still look to lower costs -- but will "guard" its margins. The contractor can cut costs through leveraged services and automation, he added.

Ken Asbury, the chief executive of CACI International, agreed. In a call with analysts earlier this month, he said companies that only focus on price might simply translate tax cuts into lower rates.

But he said CACI is seeking to differentiate itself, particularly by attracting talented employees.

"I think the idea of where we want to go is not to get trapped into, we've got to get rates lower, but we've got to get the ability to deliver outcomes higher," he said. "Those are two ends of a spectrum in this marketplace, and we're preferring to be on the upper end of that."

Bush also argued the extra margin created by tax reform wouldn’t fundamentally change the way Northrop considers whether to bid on programs.

“If you're down to the point where on a bid you’re scratching to get an incremental amount of margin, you're probably not doing the right things in terms of your architecture or your cost structure,” he said. “I would actually argue there are other things you ought to be thinking about doing to get your returns there than relying on the increment from tax reform.”