Industry Analysts: Defense Outlook a Mixed Bag
Byron Callan, defense industry advisor at Capital Alpha Partners LLC, points out in a note to investors: “No one has a clue what the national security environment could be in 2018-2021. Just as there are scenarios that can be conceived where defense spending needs are far lower than today, it does not take much imagination to conceive of ones where demands for defense equipment and services are greater.” Military threats continue to fester, he says. “We haven't heard the term "peace dividend," which was used when the Warsaw Pact and Soviet Union unraveled.”
As soon as someone suggests that defense spending can be cut because the nation is not facing a major threat, “something new and different pops up,” Callan writes. ‘U.S. troops are on the way out of Iraq, but then there are allegations of Iranian assistance for groups in Iraq that have been blowing things up and Iran test fires missiles into the Indian Ocean. Osama bin Laden is killed, but then there are reports that A.Q. [Al-Qaida] in Yemen is looking at ways to surgically implant explosives in suicide bombers and Pakistan goes after informants who passed information on to the U.S. and wants U.S. unmanned air vehicles to cease operations from Shamsi air base.”
While the “affordability” of defense budgets has been a hot topic during these times of budget deficits, “continued global military conflict, police action requirements, and need for humanitarian aid delivered on a global scale illustrates the requirement for innovation and delivery capacity of the private defense and security industry,” says Tom Captain, vice chairman of Deloitte LLP, global aerospace and defense sector leader, and author of anindustry study released July 12.
The study — which analyzes the financial performance of global aerospace and defense companies with revenues exceeding $400 million — reveals that sales and profits were flat in 2010 for the second year in a row, the industry backlog shrank by 0.4 percent and employment was down about 0.8 percent.
“An astute observer might wonder if this is a sign of things to come — a temporary lull in long-term growth or the beginning of a sustained downward trend,” Captain says.
Commercial aerospace is gaining momentum, while defense contractors struggle with a “difficult budget environment,” he says. While the Pentagon continues to spend nearly $700 billion a year, “there does not appear to be enough work to go around, which may mean decreased future revenues and profits,” he says. “We are likely to see the restructuring and acquisitions in the defense industry, among other actions, as companies seek to grow and to gain scale economies.”
Defense contractors will have to adapt to a new reality where big-ticket weapon contracts will become rarities and the Pentagon is likely to favor suppliers that offer the lowest prices, says retired Air Force Gen. Charles Wald, former deputy commander of the U.S. European Command, who now heads Deloitte’s defense practice.
The troop drawdown in Iraq and Afghanistan might generate a moderate “peace dividend,” but the Pentagon still is going to continue to spend at least $450 billion to $500 billion a year in its non-war budget, Wald says in an interview.
As these two major conflicts come to an end, there is a “belief that we’ll reduce defense spending significantly until the next crisis occurs,” Wald says. The coming downturn will not be like previous cycles because a large percentage of U.S. forces will not be in garrison, but spread all over the world, he says. There will be troops in the Middle East for a long time, Wald predicts. But rather than be engaged in combat, the U.S. military will be busy “finding the next threat,” he says. “Intelligence will be paramount.”
There will not be many large acquisition programs, but each of the Pentagon’s top-five defense contractors will remain in business as each holds a monopoly on key weapon systems. Lower-tier suppliers will merge, buy their competitors or exit the business, Wald says.
The Pentagon will have approximately $100 billion to $150 billion a year to modernize the force, so it has to carefully set priorities and measure risks, he says. “I’m hopeful this is going to be ‘the’ debate in Defense Department” under Secretary Leon Panetta. His predecessor, Robert Gates, got the process started but did not get far. Panetta told reporters recently that "one of the things I'm hoping to do is to create a vision of what the Defense Department will look like in five or 10 years."
Once the current turbulence in Washington settles over the debt deal, says Wald, Panetta will have to dig deep into the unpleasant business of reining in spending and investing smartly for the future.
“The traditional way of doing cuts is not going to do it this time, says Wald. “We need more sophisticated methodology instead of salami slicing. … How do we step away from what we know into what we have to be? How do you articulate it, build consensus, get the stakeholders on board?” he asks. “Determining the risks is not hard. The politics is the hard part.”