Defense Analyst: Industry Shrinkage Is Inevitable
The defense sector is overdue for massive consolidation, considering that Pentagon procurement spending has declined by more than one-third since 2008 and the industry has not shed nearly enough excess capacity in response to reduced sales, said Marty Bollinger, director of Booz & Company’s aerospace and defense practice.
Once the current stalemate over U.S. government spending is resolved and the dust settles on future defense budget projections, the downturn in procurement spending will continue, Bollinger said. “We still think there’s another 15 percent to go.” Even if the defense budget top line remains flat, spending on new weapon will fall as acquisitions budgets get squeezed by rising personnel, health and operations expenses.
A reasonable projection is a nearly 50 percent plunge in procurement spending since 2008. “That’s consistent with, or even less severe than, the previous defense downturn,” he said.
Defense contractors, meanwhile, continue to be saddled by huge fixed costs, mostly in facilities and staff, said Bollinger. This is only going to make Pentagon weapon systems more expensive over time, as the government pays for overhead costs.
The only way to dramatically lower procurement costs is to allow industry to consolidate in a significant way so it can shed excess capacity, said Bollinger. Even in the face of draconian budget cuts, the issue of fixed costs hasn’t been tackled by the Defense Department, he said. “We’ll be spending a lot of money to sustain idle facilities and design teams” that are not going to be producing much. “They need to take out capacity,” said Bollinger.
The Pentagon drew a red line on industry consolidation nearly two years ago, when then Undersecretary Ashton Carter warned that the Defense Department would frown on large-company mergers. “They might need to rethink that,” Bollinger said.
As it becomes obvious that fixed costs are an albatross around weapon procurement programs, the Pentagon will have to accept that consolidation is inevitable, he said. “We have to allow some thoughtful intelligent way of dealing with fixed costs through consolidation.” The government says it wants competition, but it is hard to see how that is possible in an industry that is made up of monopolies. In Navy ship construction programs, for instance, only 3 percent of direct labor hours are actually competed, Bollinger said. In the 1960s, it was 90 percent.
The Pentagon’s posture that it is not the government’s role to pick winners and losers in the private sector is irrelevant, said Bollinger. “Your industrial strategy is based on what and how you buy. That’s it.”
There are other forces at play in the defense market that will continue to pressure U.S. firms to consolidate, he said. Today’s dominant Pentagon prime contractors could in the future be relegated to niche players as nontraditional vendors — commercial firms and foreign suppliers — make inroads into the defense market, said Bollinger.
A cursory review of major Pentagon programs today paints a surprising picture. The Navy’s Littoral Combat Ship is made at shipyards owned by foreign companies, and the radars are designed and built outside the United States, he pointed out. The Army’s newest helicopter is built in the United States but was designed by German and French engineers. The Marine Corps’ artillery gun is a British design. A new secure phone for the military will be built by Google and Dell.
“There has been an injection of new ways of serving the customer, leveraging global scale, adapting existing products,” said Bollinger. “That part of the market I believe will continue to grow.”
Booz analysts estimated that one-third of new Pentagon procurements fall into that category. Excluding so-called Cold War weapon systems that the Pentagon continues to buy, much of the new technology the military is purchasing has “bypassed the traditional U.S. defense industry,” he said. “If you can bring commercial technologies and adapt them to defense needs, you have significant growth opportunities.”
The competition for Pentagon dollars will be a contest between the traditional and the nontraditional suppliers, Bollinger said. The Pentagon needs commercial firms to enter the fray so they can have real competition. “Many non-defense companies entered the market over the past decade. They don’t need the Defense Department, and view it as a high-cost, low-margin niche customer,” he said. “If you worry about competition, the main challenge is to keep these companies in the business.”
Legacy defense contractors are going to have difficulty attracting risk capital and talent unless they find a way to grow, said Bollinger. “In a down market, that would be consolidation.
Today’s major U.S. weapon manufacturers are behaving like tobacco and electric utility companies, he said. “They’re low growth, low innovation, they pay high dividends to shareholders, and manage down risks,” he said. “That’s fine, but I’m not sure those are the companies I want developing the next generation of weapons for our forces in combat, in a competitive world.”
Bollinger’s view stands in sharp contrast to the predictions of some senior defense industry executives who expect continued Pentagon investments in traditional hardware.
“I don’t see [consolidation of tier-one companies] happening,” said General Dynamics CEO Jay L. Johnson. He chalked the EADS-BAE merger to the European downturn, and not as indicative of a declining U.S. defense market.
“You could put yourself on a 10-year path of decline,” Johnson said Sept. 13 at the Morgan Stanley Industrials and Auto Conference in New York. “But the world is not going to let you do that. Instability is not going to let that happen,” said Johnson. Once the U.S. government resolves the current budget impasse after the November election, he said, the future will look less dire for defense suppliers. “The timeline for decline in defense is much shorter” than is currently being predicted, Johnson said. “I believe you’ll see opportunities for acquisitions in the lower tiers, but not in tier one.”
Photo Credit: BAE Systems