What first quarter defense earnings tell us about today's market

All three large publicly-traded defense companies headquartered in the Washington, D.C. area reported first quarter financial results this week: Lockheed Martin, General Dynamics and Northrop Grumman.

But as a reminder, the results are more than just numbers. These reports help take the temperature of the market through the lens of chief executive and financial officers.

Here’s a drive-by look at what was said, broken out into a pair of main thrusts.

Somewhat lower-key budget optimism

There were scant questions from analysts on those calls about the macro environment as it relates to the budget -- specifically the prospect of sequestration spending caps coming back into play on Sept. 30 without another agreement from Congress.

That prospect cannot be discounted given the partial government shutdown earlier this year and polarized political environment. As she has many times in the past, Lockheed Martin CEO Marillyn Hewson brought up that spending cap scenario in her scripted remarks.

“Congress will ultimately need to pass legislation to raise the Budget Control Act ceiling, which are still in effect for discretionary defense spending in” fiscal years 2020 and 2021, Hewson said Tuesday.

“We are encouraged by recent congressional support for raising the spending caps. However, we expect significant discussions to take place before the budget process will be finalized,” she said.

Hewson did note that the White House requested a $750 billion defense budget request for fiscal year 2020, which does set the tone for negotiations in Congress, and that she has seen “strong bipartisan support for national security initiatives.”

The current fiscal year’s elevated defense spending was a boon to Lockheed’s first quarter results and updated guidance for this calendar year. Revenue of $14.3 billion for the quarter was 23 percent up from last year and the company now expects $56.8 billion-$58.3 billion in sales compared to the prior $55.7 billion-$57.3 billion range.

Northrop left its revenue forecast unchanged at around $34 billion but also indicated a positive outlook on the current market environment, based on CEO Kathy Warden’s opening remarks.

“The President's FY 2020 budget includes increased investments in space, missile defense, nuclear deterrence, artificial intelligence and hypersonic,” she said. “There is strong bipartisan support for these increased investments to support the national security strategy, the national defense strategy, as well as the framework outlined in the missile defense review.

Warden also gave a number on the size of Northrop’s space portfolio: $7 billion. The company doubled down on space as a priority market through the Orbital ATK acquisition last year to gain more capability in manufacturing platforms of different shapes and sizes.

But what exactly of IT services?

This is where we shift more to what General Dynamics and Northrop are up to, given how Lockheed divested their IT services business to Leidos three years ago. Lockheed still is very much in the tech game though thanks to their vast cyber portfolio and venture capital organization.

General Dynamics just this month hit the one-year anniversary of their CSRA acquisition to dramatically reshape and recast their “GDIT” segment. Analysts are now asking more questions about GDIT versus typically wanting to know everything about their Gulfstream aerospace business.

How did GDIT do this quarter? Revenue hit $2.2 billion with CSRA adding $1 billion to that) and a book-to-bill (backlog growth versus drawdowns to book sales) of 1.1, which on a trailing 12-month basis is 1.0. The business’ profit margin for the quarter was 12.4 percent, a mark still below industry-leading Perspecta but ahead of many others.

And General Dynamics CEO Phebe Novakovic told analysts Wednesday that business is “in very good stead for continued growth” given their win rate of 70-75 percent over the last four quarters and what she said is a 5-percent increase in their addressable IT budget market to $120 billion.

“With that win rate, with the increasing budget and post-acquisition book-to-bill, we're in a very good place,” she said. “I look at this business as long-term, good growth.”

GDIT executives told reporters last month they have prioritized enterprise contracting opportunities north of $500 million that touch on key areas like IT modernization, cloud computing, cybersecurity and other growing tech tools like artificial intelligence.

But expectations are tempered given how competitive and fragmented the federal technology services landscape is. GDIT’s revenue forecast for this year remains at $8.3 billion.

“The beauty of a business with 7,000 contracts is that frankly no one is positive. But I'm comfortable that they'll win their fair share,” Novakovic said of GDIT.

Northrop has been on a path of their own to reshape how they approach technology services and position that part of the business to grow again. By design, they have shrunk that business in scale and realigned it to focus on higher-end technology work that is less weighted toward managed services but more in line with the defense core.

First quarter revenue in that business fell 15 percent to $977 million, primarily on ends of programs, a trend Warden acknowledged Northrop “certainly saw that those were quite impactful this quarter.”

But she again emphasized the longer game.

“This is positioning the business better for competitiveness in the marketplace and also margin rate performance and they delivered that this quarter,” Warden said. “We're going to continue (getting) better profile from TS as those programs roll off, several of them in this first quarter, and look toward a return to growth for TS late this year.”

That shift is paying off some on the bottom line, where Northrop expects the technology services operating margin to hit 10 percent versus the prior middle-to-high 9 percent forecast. Revenue expectations remain in the low $4 billion range for this year.