Northrop Grumman (NYSE:NOC) and Lockheed Martin (NYSE:LMT), two of the nation's largest defense contractors, both were hit by the Pentagon over quality concerns in recent weeks. None of the individual incidents are a reason to sound an alarm about either company. But the pattern, if it continues, is worrisome and needs to be watched.
Early last week, Bloomberg reported that the Army in June had issued a delinquency notice against Northrop, citing "poor contract performance related to initial supply and quality concerns" on a $3 billion helicopter antimissile system. The report also said that the Air Force had discovered landing gear installation issues and other concerns with Northrop's contract to maintain Joint STARS air-to-ground surveillance aircraft.
Two days later, the Pentagon and Lockheed Martin confirmed that F-35 fighter jet deliveries were delayed for 30 days beginning in September after a routine maintenance inspection found corrosion that exceeded technical limits.
New tech, new risks
Lockheed Martin's problems are part of a broader challenge facing the industry. Government bodies including the Environmental Protection Agency and the Occupational Safety and Health Administration, not to mention a more eco-aware Pentagon, are pushing contractors to be more environmentally responsible in their manufacturing.
The Department of Defense has been concerned about potential corrosion issues with the F-35 for about a decade, in part because of a push against using chromate salts. Chromium is one of a number of hazardous materials marked for elimination from Air Force operations and installations as part of a 2000 executive order, but the material is among the best anti-corrosion agents available.
The primary corrosion risk on the F-35 is in the areas where the plane's carbon fiber exterior fastens to its aluminum frame. Lockheed engineers have tried to mitigate the risk in a variety of ways, including using sealants more chemically similar to aluminum, and by providing adequate drainage paths designed to reduce fluid buildup and entrapment.
The good news is that a lack of protective coating was identified as the culprit, meaning it's a relatively easy fix. But given the large number of production issues that have arisen over the nearly two-decade history of the F-35 -- the world's most expensive weapons platform -- the negative headlines are an embarrassment. The F-35 is by far Lockheed's most important product, currently accounting for about one-quarter of total revenue and expected to generate nearly $1 trillion in sales over the program's lifetime.
The combination of using newer composite materials and searching for new ways to reduce corrosion is bound to create some need for trial-and-error, and the Pentagon has shown a willingness to be patient and work with its suppliers especially when it comes to new technologies. But if nothing else, the incident is a reminder of the risk of unexpected issues in multibillion-dollar programs.
Spread too thin?
Northrop's antimissile system woes similarly can be chalked up to development delays, but the Joint STARS problems appear to be more rudimentary mistakes instead of errors while wrestling with exotic new technologies. Some of the issues were as simple as an incorrect number of washers under nuts, or bolts that were not properly torqued. Those are the sorts of mistakes that could factor into future product awards, as Pentagon procurement officers are allowed to consider past performance when issuing new awards.
The air-to-ground surveillance aircraft that Northrop is maintaining is scheduled to be replaced, and the company along with Lockheed and Boeing should be among the favorites for that award. A bad experience now could make winning that potential $7 billion deal a more difficult challenge.
The issues also come at a time when Northrop has raised eyebrows by walking away from a number of procurement contests where it was considered among the favorites. Company execs attributed those decisions to a desire not to chase marginally profitable business, and talked up a desire to allocate Northrop resources in the most efficient manner possible. Taken together with the quality issues, investors need to monitor Northrop for signs that it could be at risk of spreading itself too thinly. If so, future opportunities could be at risk.
Expect the unexpected
Quality issues are not uncommon in the industry, and these problems are more likely speed bumps than reasons to run scared from these stocks. But with Northrop and Lockheed trading at lofty 23.13 times and 18.07 times trailing-12-month earnings, respectively, these are fresh reminders to an overly optimistic market that there are unknown risks to the defense titans even with a growing Pentagon budget.
Investors in these companies have had a great year, with each stock up more than 24% year to date. They'll need to keep an eye out to make sure these concerns do not become more of a long-term trend.