Hand-wringing has officially become a competitive sport in the defense industry.
A combination of fear-of-the-unknown and expectations that the boom of the past six years may soon end is causing considerable angst among defense contractors and investors.
But is the anxiety justified? It’s not that defense budgets are in danger of sinking any time soon. By most estimates, military spending will remain at historically high levels for the foreseeable future.
“I don’t see defense spending declining in the first years of the Obama administration,” says Richard Danzig, President-elect Barack Obama’s national security advisor.
For some companies, however, there are legitimate reasons to worry because the Pentagon — a notoriously fickle customer — is about to get even fickler. Internecine discord at the Defense Department about what threats the military will face — and consequently what weapons are needed to combat future enemies — will create a tough business environment for an industry that craves predictability, according to the latest forecast by the Government Electronics and Information Technology Association. Some factions within the Pentagon want the budget to fund traditional big-ticket weapons to fight peer competitors. But others contend that the real dangers are terrorists and insurgencies. The lack of consensus about the future is creating “real tension in the budget,” says Hugh Brady, a member of the GEIA team that produced the study.
Suppliers of major weapon systems also will see their budgets jeopardized by the Pentagon’s rapidly soaring “operations and support” costs, which pay for most of the expenses associated with deployments and maintenance of military hardware. “The O&S versus investment tension is a major source of frustration,” says Brady. “This will be a problem for the next several administrations.”
Investment accounts include research, development and acquisition of weapon systems. In 2009, investments consume 37 percent of the defense budget. That share will decline to 30 percent by 2019, GEIA predicts. “That’s a very worrisome trend for industry,” he says.
In this atmosphere of incertitude, defense contractors may want to rethink their strategies. Financiers look at the defense industry right now and see healthy cash flows, but they are not necessarily rushing to invest in this sector because they are wary of the Pentagon’s volatile behavior as a customer, analysts say.
“It’s hard to plan around what the government says,” notes W. Alexander Vacca, another member of the GEIA study group.
Investors frequently criticize the industry for having too much tolerance for a difficult customer. Shareholders often bemoan that, in the zeal to win contracts, companies make unrealistic promises to the government, as was the case when they told the Navy they could get a littoral combat ship for $220 million. Ultimately the ship cost more than double the original estimates and the program has yet to recover from those early miscalculations.
Troubled procurement programs are found everywhere in the Defense Department, so investors are getting jittery about what the next round of “acquisition reforms” will entail, says Vacca. The complaints are structural, not episodic, he adds. It’s not just isolated programs but whole classes of systems that are under scrutiny — aircraft, ships, space projects. Investors wonder why they should invest in an industry that has such systemic problems, says Vacca.
Companies would be wise to plan for turbulent times, but the conventional wisdom that has prevailed for the past two decades may no longer apply.
The “Last Supper” consensus appears to be breaking down, says Vacca, referring to the 1993 gathering when then-Deputy Defense Secretary William Perry advised the Pentagon’s top contractors to consolidate if they wanted to survive the coming collapse of military spending. That warning set off a five-year wave of multibillion-dollar corporate mergers and acquisitions and resulted in a much smaller industry that is dominated by a handful of powerful conglomerates.
The accepted belief is that to weather a storm companies must gobble up other defense contractors, and that they should avoid diversifying into civilian markets because that experiment was tried in the early 1990s and ended badly.
That thinking appears to be changing, says Vacca.
Confronted by an unpredictable government customer, companies should ponder branching out into non-military sectors that can help boost their bottom lines, investors told the GEIA analysts.
They believe that companies should not just think about getting bigger but also reevaluate their portfolios and smartly pursue asset-swapping with commercial firms. Some of that is already happening, Vacca says, because investors are receptive to the notion that buying unrelated companies can generate cash flow. “This was a shock to us,” Vacca says.
In a bit of good news for the small-business world, analysts foresee a potentially lucrative environment for nimble companies that can offer innovative technologies to the military but are not wedded to the Pentagon’s cumbersome acquisition bureaucracy. The advice from investors: “You can grow by doing something different and unique.”
Serious mistrust of the government seems to be the underlying theme. The financial gurus’ message to the defense industry: Do not follow your customer off a cliff.