Inflation undermines the pentagon’s ability to make deals with defense contractors

The Pentagon wants to develop advanced weapons systems to counter emerging overseas threats. Many defense contractors are avoiding projects that could turn into money-losers.

The industry’s discontent has been brewing for months and reached a crescendo this past week when Northrop Grumman NOC 0.27%increase; green up pointing triangle said it would take a charge of $1.2 billion building the first batches of the new B-21 Raider. The long-range bomber aircraft will be capable of carrying nuclear weapons and is a centerpiece of efforts to deter military actions from China and Russia.

Inflation played havoc with cost estimates Northrop Grumman made when it beat a team of Boeing BA -1.87%decrease; red down pointing triangle and Lockheed Martin LMT -0.23%decrease; red down pointing triangle for the initial contract in 2015. Pandemic-driven supply-chain challenges and labor shortages also made the first planes pricier to make.

Executives of U.S. defense contractors tried to reassure investors they wouldn’t chase projects that presented high risks for cost overruns. The comments come as several companies have record order books from the U.S. and allies stocking up on jet fighters, missile-defense systems and other weaponry.

“We have passed on some high-profile programs,” Northrop Grumman Chief Executive Kathy Warden said on an investor call last week. The company’s shares fell more than 8% after it reported the charge on the B-21, wiping $4.5 billion from its market value.

The company said in the summer that it wouldn’t bid on an Air Force program to develop high-end jet fighters that will replace the radar-evading F-22.

The Pentagon typically uses what are called cost-plus contracts to develop new weapons systems. Companies earn a fixed profit and the government covers unexpected expenses if problems emerge or contract requirements change.

When those plans are ironed out and weapons are ready for production, the Pentagon often switches to fixed-price deals. The parties agree on a price, but companies are left on the hook if costs run higher.

Executives said the balance between risk and reward from some deals has swung too far toward the Pentagon, pushing them to avoid projects that could fuel growth.

“I will sacrifice revenue for earnings and cash every day of the year,” said L3Harris Technologies CEO Chris Kubasik. The company dropped out of competing for a new Navy missile last summer, and Kubasik said last week that it had skipped another deal in the fall.

Lockheed Martin and RTX RTX 0.49%increase; green up pointing triangle, the country’s two biggest defense contractors by revenue, are both nursing losses on fixed-price Pentagon contracts.

Boeing racked up more than $10 billion in losses because of missteps in building new refueling tankers, space taxis and jumbo jets that will carry the president on Air Force One. Boeing has since sworn off entering new fixed-price development deals with the Pentagon. The company is scheduled to issue its quarterly earnings report Wednesday.

Falling profit margins have been one of the biggest concerns among defense investors, despite companies’ soaring sales. The sector has shed much of the stock-price gains that followed Russia’s invasion of Ukraine nearly two years ago, with the biggest U.S. companies down an average of 10% in 2023, underperforming the S&P 500. The sector is flat this year.

“In an environment of low inflation, people did step to the line and made bids because they were big, important programs,” said TD Cowen defense-industry analyst Cai von Rumohr. “Most everybody is getting religion now, but you don’t know how many companies have contracts in the closet that might have some risk to them.”