Defense R&D: Is the Reward Worth the Risk?

At a time when the Defense Department is eager to attract more private investment in cutting-edge technology, even the Pentagon's top contractors are taking a step back and hedging their bets.

A growing hesitance to gamble on futuristic military hardware was the clear subtext of speeches and conversations last week at Lockheed Martin's annual media day in Arlington, Va. The nation’s largest defense contractor derives most of its business from military sales but when it comes to next-generation technology, the company is not ready to make huge wagers.

"Are defense companies going to invest more to get new programs started? That's more of a commercial model. I don't see a lot of that happening in the future," said Rob Weiss, Lockheed Martin executive vice president and general manager of aeronautics advanced development programs, also known as the Skunk Works.

Weiss runs the company's most secretive and most celebrated operation that was the cradle of revolutionary military machines like the SR-71 spy airplane and the F117 stealth fighter. Most projects at Skunk Works are classified, and new technology development largely is funded by the Defense Department. Lockheed does not intend to make risky bets on technology for its own sake, Weiss said, and he sees similar behavior across the defense industry. "If industry is going to invest on the front end, then we've got to expect that you're going to get returns on the back end," he said. "At Lockheed Martin in general, we are being prudent with any internal dollars we spend to make sure there's a reasonable return on the back end."

The company is working on future concepts for surveillance and strike aircraft, but is not going to pour funds into these projects until clear "requirements" are spelled out by the Defense Department.

"Requirements are key," Weiss said. Although that is easier said than done, however. Sometimes a company works on a design, development and prototyping, and "you're not necessarily sure what the requirements are," he said. "The problem with investing early is that you may invest and the requirements move."

That is why companies are increasingly gun shy. A case in point is the Navy's carrier-based combat drone known as UCLASS. The Navy initially selected four designs but the requirements changed and some of those designs no longer met the needs, Weiss noted. "Who's going to invest to catch up with competitors that happen to be in the right space?" he asked. "I think it’s going to require much better clarity overall on what is the requirement, earlier. And then stick to that requirement so investments by industry are focused on that requirement."

Another reason corporations may hold back investments is the uncertainty that a program will survive leadership changes. Military and civilian officials, and members of Congress "come and go," Weiss said. "These programs take a long time to come to fruition. So you may have different leaders over time. A challenge for the industry is how to maintain direction even with new people."

Trailblazers like Skunk Works seek to push the limits of technology, but in the current business environment, it is best to use as much existing "proven" technology as possible, said Weiss. "What's the key to successful programs? Take as much mature technology as you can. We use it all. Every bit that we can from prior programs." Weiss is leading Lockheed's bid in the upcoming competition for a new trainer airplane for the U.S. Air Force. The company announced it would propose an updated version of the existing T-50 trainer. A clean-sheet design would be put forth if the Air Force requested it, but Weiss believes that would add risk and years to the program. "The issue is the time associated with a new development. If you need it soon, an off-the-shelf solution is the way to go."

Much of the excitement at Skunk Works today is less about dreaming up airplane concepts and more about updating current aircraft with modern information networks. "We made a huge investment in open systems architecture work," said Weiss. "We have hard data to prove the value." This is the type of technology that saves the government money because it allows legacy airplanes like the U-2 to be outfitted with plug-and-play electronics and sensors made different vendors, he said. "We are all in on open systems architecture."

The industry wants to help the Defense Department innovate, he added, but it is difficult in the current environment. During the glory days of military aviation at Skunk Works, "we had stable requirements, small teams, engineering talent empowered to make decisions, higher tolerance for risk." The system today is "not quite as comfortable" with those things any more.

Risk aversion is reflected in Lockheed Martin's latest financial reports, observed James McAleese, industry consultant at McAleese & Associates. "The sheer size of Lockheed Martin's dividends and share repurchases limits overall size of annual R&D funding," he wrote in a briefing to clients. Internal R&D in 2014 was only 1.6 percent of sales, compared to an average of 2.1 percent for its peers, McAleese noted. "Expect Lockheed Martin to invest in R&D with a two to three year payout," he added. Most of the R&D funds are going into the company's lucrative missiles and fire control sector, McAleese said, where Lockheed is investing in programs like the MEADS missile defense system and the joint light tactical vehicle.

In the space business, Lockheed is shifting focus to the commercial market. It is spending $250 million in corporate R&D to update a 20-year-old communications satellite called A2100. "We are refreshing the design and investing in new manufacturing capabilities as the commercial market is growing," said Mark Valerio, vice president of Lockheed Martin's military space business.

The modernized satellites would target the growing global market for Internet, TV, and secure communications, said Lockheed Martin President and CEO Marillyn A. Hewson. "We invested in the A2100, reducing the number of its parts and streamlining its production so our customers can get it into orbit more quickly and at a fraction of the cost," she said. "Worldwide demand for smartphones is estimated to increase by six times over the next six years. Mobile data traffic will grow by more than 11 times in five years."

Lockheed also is venturing into nondefense applications of big data algorithms that were originally created for the Pentagon. "We've taken traditional missile defense tracking technology and applied it to detect sepsis in patients in hospitals," said Keith Johnson, Lockheed Martin technical director for analytics. "We have a workforce of engineers that have a lot of experience working with data," he said. "The technology now is allowing us to use that knowledge for new customers. That's what we are seeing as we go forward."

Hewson said Lockheed is betting on potentially groundbreaking healthcare technology such as genomics. It signed a partnership last year with Illumina, a pioneer in gene sequencing. Both firms are working on "personalized healthcare" solutions that would be marketed to countries around the world.

Investors generally have encouraged large Pentagon contractors like Lockheed to transition some of its business to other markets that might offer better returns.

The Defense Department’s 2016-2020 funding projections show “flattish investment outlays,” said Byron Callan, director of Capital Alpha Partners. Periods of defense innovation, he noted in a note to investors, are not stable and predictable. “Managements that seek this sort of environment are apt to see plans wrecked by new military surprises and competitors.” Commercial technology firms earn much higher margins than defense contractors, he added. “They take far more risk than defense firms, but they also spend far more on research and development, for the most part. Commercial technology is globally available and proliferation of cheap digital electronics is one factor why the Defense Department has become so concerned.”

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