The Incredible Shrinking U.S. Defense Industry
The trend in the economic power of defense firms also is noteworthy. In 1961, in constant dollars, the Fortune 100 produced less than $1 billion in economic activity as measured in annual revenue. However, the defense firms identified on the 1961 Fortune 100 accounted for nearly 30 percent of this total, which made them economic powerhouses.
But from 1961 to 2015, while the revenues of the overall Fortune 100 have soared from less than $1 billion to nearly $8 billion, those firms in the defense industrial base have not kept pace. Defense firms have fallen from nearly 30 percent of the Fortune 100 revenue to less than 3 percent, with the pure defense firms now less than 1.5 percent. This says, among other things, that companies once having a significant defense segment, but viewing it as secondary business line, have largely sold or closed those units and exited the defense market.
When it comes to corporate earnings, the story is more complex, but not fundamentally different. In terms of generated profits, the overall Fortune 100 has become enormously more profitable since 1961. The earnings of the Fortune 100 in constant figures have increased by more than 900 percent, or by nearly a 6 percent compound annual growth rate.
This is a strong testament to the power of the U.S. economy and corporate performance. But, as with revenue, defense firms have not kept pace with this growth and have increased earnings by less than 70 percent, which translates to a compound annual growth rate of 1.3 percent.
As for margins — earnings divided by revenue — the trends reveal some interesting developments. First, in 1961 the defense companies in the Fortune 100 were, as a group, operating at a loss, the only sector doing so. While President Eisenhower was warning about the size to which the defense industry had grown, he was evidently unaware that government policies and company managerial practices were threatening the long-term health of the industry by making it unprofitable.
By the early 1990s, those companies that were only partially in defense had caught up with the overall margin of the Fortune 100, while the pure defense companies continued performing at a lower rate. The margin gap between the pure defense companies and the others widened during the 1990s, reflecting reduced levels of defense procurement after the end of the Cold War, but also the costs of the numerous mergers that occurred as the industry consolidated.
Over the past 15 years, meanwhile, the margin performance of pure defense companies has improved and now matches those of other companies in the Fortune 100.
Why and how did this happen?
In the early days of the defense industry through the early 1990s, executives with engineering and program management backgrounds largely ran the major defense firms. Their focus was on exploring new technologies and meeting customer needs. There was considerably less focus on what is now widely called “shareholder value,” something a company generates with earnings and margin.
Beginning in the mid-1990s, the engineering-based leadership of the major defense firms was largely replaced by others having a much greater financial focus, best personified by General Dynamics Chairman and CEO Nicholas Chabraja, who was a corporate lawyer with no engineering or program management experience.
These new industry leaders placed considerable emphasis on program performance and cost control, steps that markedly improved earnings.
Industry consultant James McAleese recently noted that today the major defense companies return a considerable amount of their earnings to shareholders at the expense of investments in independent research and development. This is true. Indeed, most of the major firms return over 100 percent of free cash flow to shareholders through dividends and stock repurchases, while making small investments in R&D and capital expenditures.
This reflects two things: the greatly enhanced financial focus of management, and the unique characteristics of the defense customer, who pays for most of the R&D.
McAleese argues such a small focus on internal R&D is not sustainable over the long term, and he is likely correct. But from the perspective of a major defense firm, there is little option given the Defense Department’s perceived opposition to further consolidation, instability in program requirements and Congress’s budgetary incapacity, which clouds future growth prospects. Therefore, to protect a company’s equity position, which is how publicly traded companies in the defense sector essentially subsidize their customer, dividends and stock repurchases make enormous sense.
Nonetheless, the major firms have one other option, and many seem inclined to pursue it: diversifying out of defense. Many analysts have explained the recent decision of United Technologies Corp. — the second highest ranked A&D company on the 2015 Fortune 500 — to divest its Sikorsky helicopter unit as an effort to eliminate a low-revenue and low-margin line of business. Since UTC’s commercial units, primarily Otis Elevator and Carrier Air Conditioning, have margins over twice that of Sikorsky, management clearly has decided to focus on its more profitable units and divest a unit it sees as a financial drag. Moreover, UTC has stated it will return the large majority of the proceeds of the Sikorsky sale to shareholders.
If carried out, UTC will become the latest firm to largely exit the defense market, meaning that the Fortune 100 in 2016 will likely have only two aerospace and defense members. For its part, Lockheed Martin sees Sikorsky as strengthening its position in the helicopter market while allowing it to divest much of its services business that is generating low margins.
What does all this mean? First, the military-industrial complex has gone from a major presence on the American economic landscape to a niche business. Those companies still in the defense market provide the Pentagon essential equipment and weapons, but the numbers working in the defense market are shrinking, something that should be a source of concern to national leaders.
Second, the government — both the executive and legislative branches — want more cost control and technological innovation, but many of the acquisition policies they have created are barriers to entry into the defense marketplace and are often disincentives for those in the market to remain. The UTC decision is the latest example. As long as government treats earnings (profit) as a cost to be controlled rather than an incentive to be deployed, and continues with intensive and intrusive contract and supply-chains audits, the industry will surely continue to shrink.
Finally, a smaller defense industrial base leaves little margin for error should a rapid mobilization or expansion be necessary. In cases such as when the Pentagon needed to ramp up production of armored trucks for the Iraq and Afghanistan wars, a rapid run-up was feasible. Trucks were a relatively low-tech requirement, meeting a specific and immediate need, built from existing designs and the government waived many of its normal acquisition procedures to procure and field them.
Further, a smaller base, in a country whose overall manufacturing base has already shrunk considerably, would certainly limit the technological solutions available to a military force that, because of its own shrinking numbers, is more dependent than ever on advanced technology.
Defense customers and the industry that supports them must have a close partnership. Industry must understand defense requirements, and defense customers must be fully informed of existing technologies and technological risks. This means a continual conversation that is comprehensive and candid. The current leadership in the Pentagon, starting with Defense Secretary Ashton Carter, understands this.
The time has come to translate this understanding into policies and practices that are consistent with the reality of what the defense industrial base is rather than clinging to the image of what it once was.
Tom Davis is a retired Army officer and former senior executive at General Dynamics Corp.
Topics: Business Trends, Manufacturing