For four long months, three American defense contractors have been hung up on a reef, and unable to begin work on developing a new Offshore Patrol Cutter (OPC) for the U.S. Coast Guard. Last week, that changed.
Artist's conception of what the new Offshore Patrol Cutter might look like. Source: U.S. Coast Guard
You probably recall how, in February, the U.S. Coast Guard stunned the defense contracting world when it awarded $21 million in design contracts to General Dynamics (GD 1.21%), Bollinger Shipyards Lockport, and Eastern Shipbuilding Group -- but not to Huntington Ingalls (HII 0.37%), the company currently building its National Security Cutters. The decision seemed strange not merely because it denied Huntington, one of the nation's premier surface warship builders, out of the contest at its outset. It was also curious because it gave Huntington's (presumed) slot to Eastern Shipbuilding instead -- a company that DefenseNews.org describes as "a relatively new shipyard that has concentrated on building commercial ships."
(That may be a bit harsh. According to S&P Capital IQ, Eastern is not exactly a fly-by-night operation, having been in business for nearly 40 years, and generating annual revenues in excess of $300 million as recently as 2012.)
In any case, Huntington didn't like this outcome, and filed a protest with the U.S. Government Accountability Office -- suspending work on the presumed $12 billion project while GAO took a closer look at the bid process. Four months later, the GAO has decided the contract award was kosher, and rejected Huntington's protest. The contract is back under weigh again -- leaving Huntington Ingalls on the dock.
So, what does this mean for investors?
Opportunity lost
Huntington Ingalls recorded $6.8 billion in revenues last year. That means it's just lost a contract that could have provided it with nearly two full years' worth of work -- a big loss in an already constrained defense spending environment. Calculating from company's trailing net profit margin of 4.5%, the loss of the OPC contract also denies Huntington the chance of earning about $540 million in profits -- or about $11 per share over the course of the presumed 25-ship contract.
Opportunity gained?
As investors, though, we're pretty agnostic about whether this contract ultimately goes to Huntington or to General Dynamics. To us, it makes little difference who wins -- because to be brutally blunt, we can always sell the shares of the company that loses the contract and invest in the winner instead.
In fact, when you get right down to it, the prospect of General Dynamics winning this contract might be viewed as a good thing. General D, after all, earns 7.6% net profits on defense contracting business that its various divisions win. And its Marine Systems division in particular earns nearly 12% operating profit margins -- dwarfing the profits that Huntington earns at its Ingalls and Newport News divisions.
So if the Coast Guard handing the OPC contract to General Dynamics rather than to Huntington means more profit potentially going into investors' pockets -- where's the harm in that? Assume that both contractors are equally capable of building the ship that the Coast Guard wants, and getting it built on time and on budget. All else being equal, we should probably prefer to see the contract go to whomever is able of getting the work done most efficiently -- as represented by earning more profits on the monies paid to buy the ships.
Foolish takeaway
The only real downside I see in the Coast Guard's decision, and the GAO's, is the risk that General Dynamics ultimately fails to capture this contract, and that it ends up in the hands of Bollinger or Eastern instead. As private companies, in whose profits we cannot participate, a victory by either one of them, is a defeat for investors.
