Industry Recalibrating Strategies For a Declining Defense Market

By Sandra I. Erwin
The defense market is shaping up to become a Darwinian world where winning contracts will be a matter of life or death for many companies.

Not only is the Pentagon cutting back on weapons purchases but Defense Department buyers also are under strict orders to squeeze every dime they can from every program, which should translate into less money for industry.

“If you are not succeeding you are very vulnerable in this environment,” says Frank Kendall, undersecretary of defense for acquisition, technology and logistics.

The spending spree of the past decade kept alive many underperforming companies, he says. “We don’t live in that world anymore. If you’re not executing successfully, you’re in trouble.”

Analysts say industry is faced with several choices: Exit the market, double down on defense by buying up competitors, or try to weather the storm until the next military buildup.

But in the current climate, those who choose to stay in the business will have to step up their game or industry shareholders will lose patience.

Doug Belair, senior vice president of strategy and planning at BAE Systems Inc., says companies tend to guard themselves by protecting franchise programs, improving earnings and delivering cash to shareholders. That may not be enough to survive the coming age of austerity, he tells an audience of corporate executives at an Aviation Week conference. “In the last downturn, companies that hunkered down did the worst in delivering shareholder value.”

Defense companies need to do more than just muddle along, he suggests. They need to develop disruptive products. Just like Apple sold the world the iPod, weapon manufacturers have to invent the next big thing that the Pentagon ultimately will not want to live without. “Figure out what they need that they don’t have,” Belair says.

Take a page from the commercial corporate playbook and impress the customer with forward-looking products, Belair suggests. Companies, he says, should work hard at anticipating the military’s future needs, and invest in technology so they get ahead of the customer and have something ready when the need arises.

Pentagon suppliers also need to develop thicker skin, as contractors will continue to be blamed, fairly or otherwise, for budget overruns and mismanagement of weapon programs, another analyst warns. “Many companies have not yet figured out how to adjust to an environment where they are treated as bad guys,” says Steven Grundman, a former Pentagon official and now an industry consultant. “I don’t see a coherent corporate strategy to the pretty direct dissatisfaction that this customer has with this industry.”

Chilly relations with customers might be the least of weapons manufacturers’ worries. A much bigger issue that should worry industry is whether the Pentagon can fix its broken weapons acquisition system.

“We have a long history of starting programs and canceling after we’ve spent a lot of money and we decide they’re not affordable,” Kendall tells the conference, and that hurts industry. “We curtail production or cut programs before starting production,” he says. “The requirements are set too high and we don’t confront that fact until it’s too late.”

Further, a decade of no-holds barred spending has done significant damage to the Defense Department’s buying skills, says Katrina McFarland, president of the Defense Acquisition University. “We were pressed to spend,” she says. A decade of indiscipline in the weapons procurement business is “too long,” she says. “Cost consciousness has not been emphasized in our organization over the past 10 years.”

Amid the gloom and doom, Pentagon budget projections show some modest growth in procurement spending.

According to the Defense Department’s latest fiscal trends report for 2013-2017, known as the Green Book, spending on research, development and procurement is projected to increase slightly. The Green Book forecasts a 3 percent uptick in investment accounts from fiscal years 2013 to 2014, 4 percent growth from 2014 to 2015, and additional increases of 1 percent for 2016 and 3 percent for 2017.

Many industry CEOs, however, do not buy into these relatively rosy forecasts. Fred Downey, vice president of national security at the Aerospace Industries Association, says executives see too many “budget gimmicks” in the five-year plan that give them pause. One, for instance, is the assumption that the Pentagon can save $60 billion through “efficiencies” such as cutting overhead costs and administrative expenses. Industry also worries that unless the Pentagon finds a way to control personnel and healthcare costs that are growing on autopilot, it will have to dip into investment accounts.

Investors are becoming antsy about the defense sector, says Downey. Although company profits are lower than in other industries, in the past this was counterbalanced by higher stock prices because of the greater reliability of the government as a customer. “That model is certainly under stress,” he tells a group of executives at the Air Force Association.

Corporate executives do not expect the adversarial relationship between industry and the Pentagon to improve any time soon, despite outreach efforts by Defense Secretary Leon Panetta, says Downey.

McFarland, of the Defense Acquisition University, insists that the Pentagon is getting an unfair rap for attacking contractors’ profits. “I understand that view. You hear pretty abrasive stuff in the press. But I can tell you that is not the intent,” she tells executives. “If you bring the cost down, I don’t care how much profit you make.”

Topics: Business Trends, Doing Business with the Government, Service Contracts

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