Companies See Bright Spots in Bleak Market

Military contractors were recently warned by a senior official that they are about to be “punched in the face” as the defense market takes a beating over the next several years.

That statement comes as no surprise. Sequestration and gridlock will be taking a huge toll on Pentagon spending. Budgets for new weapons will be plummeting by at least 20 percent. And Pentagon buyers will be hesitant to spend what they have, as they are still scarred by a decade of procurement flops.

Remarkably, there are still companies that have the stomach to invest in defense. Some actually view these tough times as an opportunity to win new business.

Textron just unveiled a new light-attack surveillance aircraft that can carry spy sensors and is based on a commercial Cessna business jet. The aircraft, named Scorpion, is a private investment by Textron and a partnership of 22 vendors.

But in today’s bleak market, how long can a company wait for a Pentagon order before investors lose their patience?

Textron executive Edward Hackett says the company is not expecting to “drive decisions” within the Defense Department. But he hopes that products such as Scorpion will help open the debate on the “value” that industry can bring to the Defense Department.

The company decided to take the plunge in response to what it has been hearing from Deputy Defense Secretary Ashton Carter and Undersecretary for Acquisition, Technology and Logistics Frank Kendall: Industry, keep investing, please. Bring us solutions.

The business model is rather simple: Build an aircraft at a fraction of the cost of a government-developed system, mostly by using commercial components from the Cessna line.

It remains to be seen whether industry-funded hardware such as Scorpion sparks interest within the Defense Department. Some industry insiders appear impressed by the idea. Maybe the Pentagon is not ready to buy a commercial jet to replace F-16 fighters, but other countries that have less money might consider it. All Textron needs is one customer that is willing to be the first to buy one of these airplanes. Then, others probably will follow, or so some business leaders believe.

Another company that sees the downturn in a positive light is Saab North America, which spends 8 to 9 percent of its approximately $4 billion in revenues on research and development.

That’s at least two to three times what top prime contractors spend, on average, on corporate R&D.

Saab executives will admit that investors do not always like to see so much money poured into research ventures. “It takes a lot of leadership to do it,” says Vice President Brian Lawrence.

But that is the only way the company believes it can compete with the bigger primes. Saab’s story is a cautionary tale for defense companies that primarily rely on government funding to develop new products. In the 1980s, 90 percent of Saab’s revenues were from sales to the Swedish government. After the end of the Cold War, it faced a sink-or-swim moment. It decided to start funding its own product development and branched into the global market. Now 50 percent of Saab’s business is outside Sweden.

Non-U.S. defense firms understand the politics of jobs and the industrial base and have no problem pouring funds into domestic production, licensing or codevelopment, if they are reasonably sure that the U.S. government intends to buy the product.

That philosophy is guiding new investments by MBDA Inc., the U.S. subsidiary of Europe’s largest missile manufacturer. It is actively marketing its Brimstone air-to-ground missile — whose development was funded by the United Kingdom — to the U.S. Air Force, Navy and Army. This might seem overly ambitious, as the market is owned by Lockheed Martin’s Hellfire. But the company believes it can beat incumbent suppliers if given a chance to compete.

Some industry CEOs remain skeptical that the Defense Department can be trusted to commit to buy products that it did not design or develop in house. This is often known as the “not invented here” syndrome.

The government is asking industry to invest in new technology, but for some corporations, that is too big a gamble. David Melcher, CEO of Exelis Inc., a supplier of high-tech military equipment, says he expects most industry investments will be based on “requirements” set by the Defense Department.

As the downturn loomed, Defense Department leaders assumed that they would have to slash R&D spending and industry would pick up the slack. Melcher cautions about overblown expectations that industry will deliver products at high technology readiness levels not knowing whether the Pentagon will buy them. “At the end of the day, our board and our shareholders will not want us to keep investing in something that doesn’t have a return on the invested capital,” he says.

Melcher might have a point. A new study by the Center for a New American Security contends that the U.S. military “strongly resists serious investments in technologies that may threaten perceived ‘core’ weapons platforms and traditional concepts for their employment.”

Risk aversion is a “deeply rooted facet of Pentagon culture,” the CNAS study says.
Government buyers eventually will have to decide whether their desire for innovation will trump entrenched thinking. They will need to keep in mind that the modernization of the military largely will be made possible by advances in commercial technology. “The commercial sector now catalyzes far more technological innovation than the military industrial base,” says the study.

This is good news, CNAS analysts note, because a healthy commercial industry will generate innovative technologies that can be applied across the entire U.S. economy while also allowing the military to benefit from private investments.

The Pentagon, however, will always need technologies that are not available in the civilian world, and will have to make sure it invests in those areas. And if it wants defense contractors to put more skin in the game, it will also need to do a better job informing companies about its needs. The Pentagon is asking industry to invest in technology not only because it is cash strapped but also because it is in danger of losing its technological edge.

Lawrence notes that one of the biggest hurdles his company encounters in its defense business is the way the Pentagon articulates its requirements.

“The defining of requirements for new weapon systems in the U.S. needs a complete overhaul,” he says. “I think a lot of people would agree with this.” Military buyers often write requirements that are too restrictive or too difficult to achieve, he said. “That is why we have so many programs that are over budget and behind schedule.”

Topics: Defense Contracting, Defense Department, DOD Budget