The State of the Defense Industry Is Strong But…

Things are looking up for defense CEOs. A two-year budget deal recently struck by Congress and the White House should give Pentagon contractors a respite from the fiscal cliffs that have been the norm during the Obama administration. And despite unprecedented outreach to the commercial tech sector by the Pentagon, Silicon Valley is not likely to pose any real competitive threat to established weapon makers. Not a bad place to be, compared to the gloom and doom that beset the industry when sequestration budget cuts hit in 2013.

Industry chatter, interviews and comments by senior leaders Nov. 7 at the Reagan National Defense Forum, however, suggest there is lingering angst about how the industry will adapt to new demands and Pentagon expectations.

House Armed Services Committee member and pro-defense lawmaker Randy Forbes, R-Va., highlighted a central challenge for the industry: It is in good enough shape today, but can it rise to meet emerging and “beyond the horizon” crises that could require nontraditional responses? Anyone who wonders whether the U.S. defense industrial base is strong needs to qualify the question, “strong enough to do what?” Forbes asked during a panel discussion.

“I have serious questions” that the industry is nimble and innovative enough to “bend the curve line and raise it” if an unexpected conflict erupts, Forbes said. The defense sector is smaller and less consequential to the national economy than at any time in recent decades. Many small and mid-size companies are exiting the market as government red tape, restrictions on profit margins and fiscal uncertainty become too big a burden. “It’s not just Silicon Valley that sees barriers,” Forbes said.

In Forbes’ shipyard-heavy district where the Navy’s aircraft carriers are built, the shrinkage of the supplier base is quite noticeable. During the construction of the first ship of the Ford-class aircraft carrier, the CVN-78, 28 percent of contracts were not competitively awarded because in each instance there was only one qualified vendor. Six years later when Huntington Ingalls started building the second ship of the class, the CVN-79, the share of sole-source contracts rose to 40 percent, Forbes said. A similar trend is seen in the procurement of Coast Guard cutters.

The budget battles of the past six years have taken a toll on the shipbuilding and other sectors of the industry, and it could be a while before business gets back on track, said Huntington Ingalls Industries CEO Mike Petters.

“People today get lathered up about those ‘star wars’ innovations” and tend to forget that, in big-ticket military programs, there are other important, though less glamorous priorities such as funding stability, Petters said in an interview at the Reagan forum held at the presidential library in Simi Valley, Calif.

The industry hopes to be able to move past the sequestration battles that have derailed complex, multibillion-dollar construction programs which take years and require early planning, said Petters.

“The government operates on an annual budget cycle and businesses like ours operate on a long-term investment and return cycle.” Washington gridlock “has turned the most strategic thing the government does, which is national security, into an annual budget exercise,” said Petters. 

Most members of Congress who never served in the military or worked in the defense business are unaware that there is a “long-term commitment that is required just to get that ship over the horizon,” he stated. “There are thousands of companies and tens of thousands of people standing behind that sailor.” Because of schedule disruptions to ship maintenance and construction following the 2013 sequestration, Huntington Ingalls will be laying off 1,500 workers. “The worst part is that 24 months from now we are going to start to try to bring those workers back,” he said. “This is not the most efficient way to do this.”

Military leaders in attendance at the Reagan forum weighed in on the state of the industrial base. Marine Corps Commandant Gen. Robert B. Neller said he would like to see more investment in programs to modernize the fleet. His troops are in high demand and need more ships, but the Pentagon’s budget troubles have kept acquisitions on hold. Both the industry and the government are to blame, he said. “We have to do things faster. We want things to be cheap, easy and smart, I got it, but we don’t want it to be hard, stupid and expensive.”

Chief of Naval Operations Adm. John Richardson shares that view. “We are creating HOV lanes around the traditional acquisition system because speed is such an essence,” he said. “I don’t know that we are going to enjoy long holidays of technological advantage. It’s just the nature of the world that it’s going to be a much shorter holiday. We’ll have to work faster, move faster. "I see the pace of technology picking up very quickly," said Richardson. "How can we better learn how to acquire systems, so we can ride this technology curve, and have even the faintest hope of keeping up with the technological advances that are going on?"

Amid rising concerns about the military falling behind the technology curve, defense executives acknowledge the industry has an image problem. The sector tends to be associated with old-line weapons manufacturers that are out of step with the innovation happening elsewhere. Defense Secretary Ashton Carter’s outreach to Silicon Valley, especially, has moved the issue to the forefront.

“The defense industrial base is diverse and produces eye-watering systems for our military,” said Arnold Punaro, CEO of the Punaro Group and chairman of the National Defense Industrial Association. “There is this image of our industry as a monolith that builds old stuff from Word War II. That’s not our industry today,” he said during a panel discussion. In Silicon Valley, they do not build military equipment, he noted. “They design software, they have ideas, and we want to bring that in as well.”

Punaro and other Washington insiders recently toured the Valley and met with entrepreneurs and venture capitalists. Although the conventional wisdom is that these players want nothing to do with defense, “I was surprised by how open minded and receptive they are,” said Punaro. “DoD has done a good job explaining to them why we need their help.” But the Pentagon still has work to do in order to attract more firms to the defense market, he cautioned. Among the roadblocks are government imposed limits on profit margins. Silicon Valley startups aim for 30 to 40 percent margins, Punaro added. “With Shay Assad, you’re never going to get the kinds of profits they’re used to.” Assad is the Pentagon’s director of pricing and a longtime proponent of policies that require Defense Department contracting officers to challenge vendors’ prices and profit margins.

Gwynne Shotwell, president and chief operating officer of SpaceX, struck a conciliatory note, considering the company’s rocky relationship with the Pentagon since it began its foray into the military space launch business. “The conversation is a bit different now than it was a year and a half ago,” she said. “It feels different to me. Entrepreneurs feel the government truly wants to reach out.” It is now up to the Pentagon to show it is serious before Silicon Valley loses patience. “Entrepreneurs won’t wait forever,” Shotwell said.

SpaceX founder Elon Musk for years has pressed the case that commercial companies like his invest in innovation far more aggressively than traditional defense contractors, and called out the Pentagon for choosing to continue to do business as usual.

Such rhetoric has ruffled some feathers. Wes Bush, chairman and CEO of Northrop Grumman Corp., warned that the defense industry brand has been tarnished by repeated complaints that military contractors are not innovators and can't be counted to invest in cutting-edge technologies. Northrop Grumman, like other major Pentagon contractors, has come under criticism for pulling back on independent R&D spending in favor of stock buybacks and dividend payments to investors. “There is an invalid comparison of how much we invest versus what the commercial sector invests,” Bush said at the forum. “It hurts the branding of the industry.”

What goes unrecognized, he added, is that defense companies invest in products that are never commercialized because they are purposely developed in secret and out of reach of U.S. adversaries. ‘We have to be careful about the vocabulary we use. It sends the wrong message,” Bush said. “Today the real issue is regaining our technological superiority, moving us back to a place where we are confident that we actually have superiority.” That requires both industry and government to take financial risks, he said. A decline in defense R&D spending in recent decades is a telling measure of priorities. Bush lamented the absence of a “sense of urgency” about the U.S. military losing its technological edge.

Top weapons buyer Frank Kendall, undersecretary of defense for acquisition, technology and logistics, disagrees. “I think there is a sense of urgency,” Kendall told National Defense. “I certainly have it.”

The frustration expressed by Bush and others is about the bureaucratic inertia that leads to the conclusion that the Pentagon is in no rush to buy or field anything. Kendall agrees that defense programs do get bogged down in the procurement bureaucracy, and that reality will be hard to change. “It’s hard to get our people to do things differently,” said Kendall. “They’re a little bit risk averse, they don’t like to lose a protest. They’re worried about the inspector general investigating our purchases, such as when they pay too high a margin. Those things tend to drive people’s behavior.”

Kendall hopes that a happy medium can be struck between responsibly managing programs and allowing oversight to stifle innovation. “I have reinforced that over and over,” he said. “It’s a work in progress.” He said he is optimistic about the prospect of luring fresh talent into the defense market. The Pentagon’s Silicon Valley outpost, the Defense Innovation Unit-Experimental, is just getting off the ground. “DIUX is intended to be an accelerator, to bring in technology from nontraditional sources,” Kendall said. He called it a “myth” in the startup community that the government cannot be trusted to protect companies’ intellectual property and respect privacy rights.

Commercial firms that might be eyeing the government market should keep in mind that there are fundamental differences, Kendall explained. “In the commercial business there is no requirement for the buyer to be fair. The government does have that requirement. Protests exist because the government is supposed to be fair, and there are statutes we have to comply with.”

There is still big money in defense research and development work, Kendall noted. The Pentagon spends $65 billion a year on R&D, which should offer some incentives for innovators to give government work a try. Northrop Grumman, for instance, was just awarded a $21 billion contract — which is currently under protest by competitors Boeing and Lockheed Martin — to design a new stealth bomber, and the entire R&D bill will be footed by the Defense Department. “The defense market is very different,” Kendall said. “Most customers don’t pay for R&D, the government does. We pay for specialized products that take a long time to develop, and every program doesn’t make it to the market.”

Topics: Business Trends, Doing Business with the Government, Defense Department, DOD Budget, DOD Leadership, Procurement