Some super boring finance stuff about stock buybacks
A few weeks ago, Matt Levine wrote an article entitled "People are worried about oil stock buybacks" where he wrote about how the oil-and-gas industry is using its record-setting profits to return money back to shareholders in the form of buybacks rather than invest in new energy supply. In that article, he suggested that it's pretty reasonable for oil-and-gas companies to return cash to investors instead of investing excess profits into whatever comes next:
One thing that I think, though, when people get angry about stock buybacks generally, is that there are probably a lot of industries like this? “We do a business, it makes money, we have a lot of money, but eventually this business will end and we won’t be good at whatever replaces it, so we might as well give the money back to shareholders so they can recycle it, instead of naïvely reinvesting in a business that can’t last forever,” is probably the right way to think about things a lot of the time!
Well, although there may be other industries, the one I write about is the government. Which means it's time for me to write about the yawn-inducing, very boring, total snoozer Department of Defense Contract Finance Study Report, published in April 2023.[1]
And the report, which generally concludes "wow gee willikers the defense sector is profitable", found that that stock buybacks and dividends have been on the rise for publicly traded defense contractors while Independent Research and Development (IR&D) and capital expenditures have declined.
Given political sentiment around stock buybacks, and fears around great-power competition and innovation, this sort of finding is pretty notable. As a matter of national policy, my sense is that most folks probably want defense contractors to be spending cash to stay ahead of our adversaries instead of, I guess, giving it back to investors so we can pay for the Netflix subscriptions we've been freeloading.[2]
Still. There's a pretty reasonable counter-argument here; if everyone has been doing stock buybacks over the last few years, it's reasonable for defense contractors to also do stock buybacks.
At a macro level, defense contractors have shareholders they need to respond to. And if the market is super hot on buybacks, I imagine it would be a tough board meeting to pitch running against the trend out of a sense of patriotic duty. No, I'm sorry, the fiduciary duties are to the shareholders, not the American public.
Fine.
But, y'all, there's more and I just have to write about it.
We've talked about allowable and unallowable costs before. The basic idea is that, for some contracts in particularly risky contexts, the government uses a type of contract called a "cost-reimbursement contract". And in a cost-reimbursement contract, the contractor is allowed to just bill the government for allowable costs. As I've said before: It's a sweet deal!
You can imagine, though, that DOD is pretty peeved by the fact that it's giving out these cost-reimbursement contracts and defense contractors aren't taking on any risks with their IR&D spending:
What the current financing study reveals, however, is that for defense firms, IR&D spending is not about “putting money back into the business”. IR&D, as an allowable, profit-generating cost on defense contracts, is a generator of revenue, profit and cash for defense contractors. This applies whether the IR&D efforts produce technological advances or not...
IR&D charged to defense contracts is often referred to as an “investment” a contractor makes on behalf of the warfighter. However, this study demonstrates that IR&D charged to defense contracts is an investment by DoD and is a generator of revenue, profit and cash flow for the contractor.
Shots. Fired.
Is it fair for DoD to claim that taxpayers are the primary investor? I am not so sure. It's not like all government contracts are cost-type contracts. And, government contractors do have to make investments to get the government contract in the first place. The studies cited by DoD don't really dig into contract-type and corporate finance, so categorically claiming that IR&D is a DoD investment may feel a bit stretchy.
And yet, I just love this twist on Matt Levine's mental model. Here, it's actually not reasonable for a defense contractor to say "We do a business, it makes money, we have a lot of money, but eventually this business will end and we won’t be good at whatever replaces it."
Defense contractors don't really believe that, like, some scrappy upstart VC-backed firm will invent a better hypersonic missile or whatever that will disrupt the defense industry and therefore stock buybacks will lead to military superiority. Nah! That's not a thing.
Instead, for defense contractors, it's just entirely reasonable to say "We do a business, it makes money, we have a lot of money, and we can make even more money by having the government invest in our R&D instead of us paying for ourselves!"
Indeed, DoD finds the fact that IR&D is going down at all to be "perplexing" given that IR&D in the defense sector is a profit center, not a cost center!
So what should the government do about all of this?
In what feels both (a) totally sensible[3] and (b) like pouring a thimble of water on a campfire, the only real policy recommendation of all of this is that contracting officers spend some more time understanding discounted cash flows! Seriously!
The report explains that DoD has developed "the DoD Contract Cash Flow Model", which is created to help contracting officers "calculate the approximate IRR for a prospective contract scenario.... The DoD contract cash flow model was designed to be simple to use, requiring the user to enter or select only a few key elements of a contract scenario to include contract cost and profit, contract type, contract length, financing method, and the number of deliveries." And the only actionable recommendation is for DOD to "continue evaluating its new cash flow model, make any improvements as needed, and use this tool to educate the acquisition workforce in partnership with DAU."
I dunno, y'all. It sure seems unlikely to me that having contracting officers working Excel sheets is going to change market trends.
But, hey, if the DOD is going to be an investor and generate revenue, profit, and cash flow for the defense sector, I guess it might as well start worrying about IRR like the rest of the investment world?
[1] Wait. I can fix that. Spice it up a little bit, you know? It's the DOD OUSD A&S - DPC CFSR! Ah, that's better...
[2] Thanks mom!
[3] I say totally sensible because I certainly don't expect DoD to be out there saying something like "Ultimately, breaking up the big primes is the best route to reform." After all, DoD is, y'know, a federal agency and it has limits on what it can suggest![3a]
[3a] I also don't expect DoD to be out there saying things like "maybe we should revisit the widespread use of cost-reimbursement contracts that incentivize this sort of behavior". Because that would be ridiculous, right?!