By Jon Sindreu
In the defense business, Silicon Valley's motto of "move fast and break things" doesn't always ensure victory.
There is a divergence across military contractors. The stock of Palantir Technologies, which is riding the artificial-intelligence boom, is up 34% from a week ago, after the software and data-analytics giant reported 75% growth in earnings-per-share for 2024.
At the same time, shares in Lockheed Martin, Northrop Grumman and General Dynamics have fallen over the past six months. Put together, their market value is now less than Palantir's.
This is in part because Elon Musk's Department of Government Efficiency has led investors to believe military procurement will be reshaped to cut waste, let in new entrants and give priority to software, drones and robots. Palantir, as well as Musk's SpaceX, OpenAI and robotics and AI specialist Anduril Industries, are cheering for change at the expense of the legacy players.
"We sense a huge amount of fear among the traditional system integrators and providers here," Palantir Chief Technology Officer Shyam Sankar told analysts last week. Some legacy software projects, he added, are "sacred cows of the deep state."
A lightning rod for criticism of the Pentagon, including by Musk himself, has been its use of "cost-plus" agreements, which reimburse contractors for expenses incurred and add a fee or profit margin on top.
Cost-plus contracts were infamously used in Lockheed's F-35 Lightning II, not just for developing the jet fighter -- as is almost always the case, since research has uncertain outcomes -- but also to buy several initial batches of it. Only later purchases of the aircraft, which has become the most expensive military program in history, have started placing the burden of cost overruns on the company rather than the public purse.
This is why the Air Force is now buying the first, limited-production units of the B-21 bomber, in development by Northrop Grumman, under "fixed-price" contracts. The U.S. Space Force, created by President Trump in 2019, strongly favors them too, as do the Silicon Valley challengers.
Indeed, analysts believe that the shift away from cost-plus will accelerate under Defense Secretary Pete Hegseth, who has pledged to make procurement nimbler.
But the industry has been down this road many times before.
In the 1950s, officials made heavy use of cost-plus contracts to foster innovation. In response to huge expense overruns, Secretary of Defense Robert McNamara introduced "total package procurement" in the 1960s, which involved fixed-price deals. After many firms bid too aggressively for projects and ended up bankrupt or close to it -- Lockheed had to ask Washington for a bailout -- the framework was abandoned. Yet fixed-priced contracting regained popularity in the 1980s, and the private sector once again burned its fingers. The pendulum has kept swinging back and forth since.
As much as upfront setting of prices is the standard in the private sector, defense procurement is different. Yes, today's highly consolidated defense industry gives contractors more leverage, but it is also exposed to a single customer with unrealistic and ever-changing goals. Big, generational programs are scarce, and firms must bid aggressively or risk losing a core business segment.
This was the case with the B-21, which has now caused large write-downs for Northrop. And, in its recent fourth-quarter earnings report, Lockheed recorded a 72% drop in operating profit alongside a $1.7 billion charge on fixed-priced contracts, mostly related to missiles. In its own quarterly release, Boeing took a $1.7 billion hit related to fixed-price contracts on its T-7A jet trainer and the troubled KC-46A tanker -- both further examples of "must-win" contracts that incited bidding wars.
As a result, the old guard has become cautious. Capital Alpha Partners analyst Byron Callan points out that it may be the newcomers that risk overbidding for programs in the years ahead.
"Ultimately, I don't see how the smaller guys are immune to the same problems that have caught the traditional players," he said. "A pandemic, inflation and labor issues upset the apple cart of assumptions they made when they bid for these contracts."
None of this denies the market's thesis that prime military contractors have gotten complacent, and that the likes of Palantir and Anduril can reap large rewards from expanding their defense foothold, especially since their investors are laser-focused on growth. In the case of software, which has shorter development cycles and a blurrier line between development and production, the recent pivot toward fixed-cost contracts and tapping upstart bidders has a greater chance of being successful.
Great strategists, however, must learn from the mistakes of the past.
Write to Jon Sindreu at jon.sindreu@wsj.com
(END) Dow Jones Newswires
February 10, 2025 05:30 ET (10:30 GMT)
Copyright (c) 2025 Dow Jones & Company, Inc.
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