Defense Downturn Should Be Manageable

The defense industry lobby made a strategic miscalculation by using job-loss scare tactics in the fight against Pentagon budget cuts. The sequester in 2013 did not result in massive unemployment, and the profits of top Pentagon contractors experienced historic highs.

The bipartisan budget agreement that essentially freezes defense spending for 2014 and 2015 gives the industry some relief. It also will compel Pentagon contractors to make key decisions about their long-term future.

The realization that there will be no big-time industry collapse — and that the downturn will happen in dribs and drabs — should spur the defense industry to plan smarter strategies so it can survive lean times and lay the groundwork for future growth, analysts suggest.

The budget deal that Congress approved last month provides much needed clarity following nearly three years of frustrating gridlock and virtual paralysis in the defense sector.

The defense market is on an inevitable downward slide, but not headed over the cliff.

After Pentagon spending peaked in 2010, industry waited for the other shoe to drop. The reality has been a softer landing. In 2012, the top 20 U.S. defense contractors experienced a 3.3 percent reduction in revenues. Through the first nine months of 2013, the top 20 saw revenues dip by 2.5 percent, according to estimates by the consulting firm Deloitte LLP. For 2014, sales are projected to slip by 2.5 to 3 percent. “It’s a slow drip,” says Tom Captain, vice chairman of Deloitte’s aerospace and defense sector. Without the fear of a precipitous plunge, the industry now has an opportunity to make a “strategic change,” he says.

Top defense firms have performed well financially, above Wall Street’s expectations, by playing by the rules of corporate efficiency — shrinking staffs, closing facilities and buying back their stocks. Companies, however, need a sustainable strategy for long-term growth, Captain says. That means they will have to make investments, either through mergers and acquisitions, or by funding next-generation technologies that hold promise of a big future payday.

A much-anticipated wave of corporate mergers, acquisitions and selloffs in the government contracting sector should begin in 2014, Deloitte analysts predict, although there will not likely be any blockbuster deals involving the top five Pentagon contractors.

The restructuring might not make big headlines but could, over time, reshape the industry in significant ways. Some acquisitions will permit entries into new markets. Weak companies will consolidate to create economies of scale.

The simple truth is that there will not be sufficient work to sustain current levels of revenues and earnings. The epitome of how to cope with a defense downturn is what General Dynamics did after the Cold War, says Captain. GD sold two-thirds of the company and transformed itself. Others such as L-3 became a force in the industry by scooping up dozens of companies in different lines of business. Similar dynamics will play out in 2014. Captain predicts this will be a good year for bargain shoppers as the value of many companies will fall in a declining market.

Besides acquiring companies, defense contractors should be thinking about spending on advanced technologies and products that they know the Pentagon wants and is waiting for the private sector to develop. This can be a polarizing issue in boardrooms because many CEOs grew up in a risk-averse culture and are reluctant to bet shareholders’ money on dicey technological ventures without some assurance from the government that it will purchase those products. In the current climate, Captain says, defense businesses need to become more entrepreneurial. It would behoove CEOs to take more risks if they hope to continue to deliver profits during what could be a decade-long Pentagon budget crunch.

Corporate investments typically are guided by so-called “requirements” that are set by each branch of the military as they project future equipment needs. That business model has worked for decades and is likely to continue. But as the government pulls back on research-and-development investments, it is increasingly expecting the private sector to take the lead. Letting industry assume more risk is the approach that NASA has chosen as it seeks cheaper means to deliver cargo and astronauts to space.

Companies that are able to anticipate the government’s wishes “work within the system to shape requirements so there will be money,” Captain says. Many traditional defense companies, though, are not wired that way. “I would be concerned that they are not going to do well in this downturn,” he says. An industry that does not innovate unless there is a “request for proposals” is destined to shrink.

Many of the winning technologies that will improve industry’s fortunes already have been identified.

By most experts’ account, the military is looking for big technological breakthroughs in intelligence collection and data processing. The ability of pilots in cockpits and drone operators to accurately pinpoint enemies on the ground — and avoid civilian casualties — has been a consistent weak spot for the U.S. military and intelligence agencies. “The ability to know, process, and react in real time to events on the ground, in the air, and at sea will continue to be a strategic competitive advantage in armed conflict,” a Deloitte study says. “The ability to process mega-billions of data bits provided by high resolution optics, communication sensing, and other multispectral sensors, is key to differentiating friend from foe, or tactical threat versus benign events.”

Software tools to help sift through data and make sense of it will continue to create lucrative sources of business, the study says. Other money makers will be long-endurance unmanned aerial vehicles that are equipped with sophisticated cameras and sensors. Building drone airframes, in itself, will not be profitable as they become low-cost commodities, but the “payloads” are the holy grail. One of the Pentagon’s largest contractors, The Raytheon Co., has repackaged the sensors and cameras it developed for military aerial surveillance into commercial payloads used to monitor highway toll systems in various states.

Regardless of which path they pursue, companies are advised to avoid wild-goose chases. “There has to be a strategy,” Captain says.

The undeniable truth is that the Pentagon is not going to stop spending, and that the U.S. military budget is still larger than the next 15 countries’ combined. The industry will do fine, but the market will not be what it was.

Topics: Defense Department, DOD Budget, DOD Policy