Defense Downturn Sets Off Mergers, And a Search for Non-U.S. Customers

By Sandra I. Erwin
It has only been a few weeks since Secretary Robert Gates unveiled his 23-point plan to rein in spending at the Pentagon.

But the defense industry is wasting no time to maneuver into position for the coming downturn. Even with promises of flat or slightly higher future defense budgets — Gates said he is hoping for 1 percent annual growth — there still will not be enough work to keep every company in business, or to satisfy the demands of shareholders who have been spoiled by a decade of double-digit growth.

Even before Gates launched the current “efficiencies” campaign, the industry had seen the writing on the wall and started to consolidate. Now the pace will only accelerate. “Mergers and acquisitions are back in a big way,” says Tom Captain, vice chairman of Deloitte’s aerospace and defense business.

Corporate mergers and takeover deals are up in value by 300 percent from a year ago. Companies are also shaking up their portfolios as they dump what they perceive as losing sectors — shipbuilding, military hardware manufacturing — and jockey for new business in hot markets such as intelligence, cybersecurity and information technology services.

The industry also is courting new customers. More aggressively than ever, defense firms are flocking to the Middle East and Asia in search of emerging markets. Captain says he recently returned from a trip to India. “Everyone’s there,” he says. “Companies go where the money is.” India is expected to spend $80 billion on new weapons and space systems over the next five years. It’s only a small fraction of what the United States spends, but the industry still regards it as a promising region where, once you get a foot in the door, opportunities could blossom.

In this survival-of-the-fittest climate, it is only natural that firms begin to shed excess fat after a decade of bloat. Deloitte recently published a number of surveys that portray an industry that has thrived financially but started to plateau about two years ago. The average per-employee profit is up 108 percent since 1991, Captain says. U.S. defense industry has been handsomely rewarded during the post 9/11 buildup, he says, and now it is time for corporations to worry about whether they can afford their own future.

Profits and revenues have been flat for 18 months, says Captain. The only growth ahead will be from mergers, acquisitions and foreign military sales.

Interestingly, even though industry’s profits swelled during the past decade, employment has been on a downward curve. The aerospace and defense work force gradually has slipped from 1.1 million to 600,000 in the last 14 years, Captain says. Another 10 percent drop is expected.
“Original equipment manufacturers and large platform contractors are shedding more and more of their manufacturing and subsystem assembly work,” a Deloitte study says. This may be of concern to the Defense Department because lower-tier suppliers are taking on increasingly complex design and manufacturing tasks. These lower-tier suppliers are the ones most likely to be affected by the next wave of industry consolidations. Deloitte predicts the Pentagon’s big-ticket programs may see some turmoil as a result. “In fact, some key tier-two and tier-three suppliers are becoming critical bottlenecks and wielding significant power over much larger prime contractors.”

Industry mergers typically spark breathless predictions of monopoly-dominated markets and the impact they would have on the cost of weapon systems. But nobody should panic yet, Captain says. Yes, there will be fewer firms, but below tier-one contractors, which already are monopolies, most sub-tiers will still have at least two competitors.

A far more worrisome augury for the industry — as well as for the Defense Department — is not the advent of more monopolies but forecasts that show that even with a relatively stable procurement budget for the coming years, programs may be canceled because of continuing cost overruns.

Recall the scary Government Accountability Office report that documented nearly $300 billion (26 percent) in weapon programs’ overruns in 2007. That study rattled the entire industry and unleashed a torrent of new procurement-reform legislation.

Now there’s even scarier news. Things are only going to get worse, according to Deloitte estimates. “At the current pace, unless game changing mitigations are implemented to address the root causes … by 2018 the average cost overrun may exceed 46 percent, up from 26 percent.”

This projection is another reason why the industry has to be prepared for more cuts, Captain says. “It is not a good trend.”

In a nutshell, there is a mix of bad and good news. The U.S. defense budget will level off, and the international demand for U.S. technology will expand. In that vein, Deloitte has a bit of advice for industry professionals who want to prosper in the coming downturn: Acquire knowledge and expertise in export laws, foreign markets’ regimes and protocols, partnership building and understanding of cultures.

For the industry, a new world order is, indeed, coming.

Topics: Defense Department, Defense Watch, DOD Budget, DOD Policy

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