Red Flags Raised on Defense Industry Future

It is now an article of faith that the Trump administration will be beneficial to the defense industry.

Even before any meaningful details are revealed on the incoming president’s future defense plans, the market is operating on several key assumptions. Among them is that the congressional spending caps will soon be gone, the Pentagon will see bigger budgets and contractor regulations will be rolled back. If this happens, industry will inherit a business landscape that it has not seen in almost a decade.

Amid the happy talk, though, is a more subdued but no less salient discussion in corporate boardrooms about market forces that loom large for the defense industry regardless of how much money goes the Pentagon’s way.

Every industry fears disruption and the defense sector, particularly, tends to resist change. During every military spending downturn, the industry has been content with hunkering down and weathering the storm. In the most recent down cycle, the top defense contractors deployed their cash reserves to bolster shareholders and they have been handsomely rewarded for that.

Pentagon leaders have scolded the industry for its risk-averse behavior, to which executives have responded by vowing to step up investments in defense technology, if and when they get more clarity on funding projections..

Against this backdrop comes new research by industry consultants that sheds light on the behavior of defense and aerospace companies and raises questions about their chances of continuing success in the coming years.

By most accounts, defense is a thriving industry, says Erich Fischer, U.S. aerospace and defense analyst at Deloitte Consulting. But there are storm clouds looming, he warns. Executives “really need to rethink company strategies as well as how the business is executed.”

It’s easy to become complacent now that defense budgets are headed upward, unleashing a renewed confidence in the defense sector, Fischer observes. The reality is that segments of the industry could soon be threatened by competitors that are more willing to take risks.

Over the past 25 years, many aerospace and defense companies have stuck to strategies and business models that more or less “stayed the course” despite significant changes in the landscape, Fischer says. His data shows that these companies exhibited poorer performance than those that adapted their strategies and business models to changing environments and market needs. The companies that adjusted, he says, outperformed those that didn’t by up to seven times.

Bottom line: Much of the industry is at risk from disruption.

Some of the reasons are obvious to industry watchers. The democratization and globalization of technology, as well as massive private investments that have spurred innovation are forces that increasingly are “opening the door for more nimble competitors and new entrants,” Fischer says.

This should be of special concern to companies that are serving a particular market and all of a sudden that technology becomes mature or that market globalizes. “So you start to now compete against companies that may be introducing commercially derived platforms at much lower cost,” he says. “That’s a fundamental change.”

Evidence of that is surfacing in the robotics market, for instance, where commercial companies are offering autonomous vehicles at one-tenth the cost of traditional military platforms. Manufacturers of highly sophisticated weapon systems have been immune from these disruptions but even this sector is facing pressure to cut costs as the Pentagon continues to be reminded that shooting million-dollar missiles and flying $100 million airplanes in today’s wars is a cost-benefit loser.

Deloitte estimated that about 60 percent of aerospace and defense revenue is associated with units whose business models no longer actually reflect the needs of the market. The top defense firms have been the most reluctant to shift course. Across the largest 20 defense companies — for which aerospace and defense constitutes more than 50 percent of total revenue — roughly 25 percent of total shareholder return between 2009 and 2014 (roughly $93 billion of $366 billion) is attributed to financial techniques as opposed to returns generated by underlying operational performance.

There’s really nothing wrong with that, Fischer insists, but when one looks at the shareholder returns that are based on core operations and not associated with share buybacks and dividends, it is striking to see the gap between defense and commercial companies.

Paying cash to shareholders is certainly a “very important lever that companies can and should use at appropriate times,” says Fischer. “I think now that you are seeing defense budgets start to rebound ... I suspect we may see ... a different dynamic.”

So how might companies’ behavior change? Deloitte analysts see a growing sense of urgency. “There’s an increasing amount of discussion around this in the industry right now,” he says. Can they continue to bet their growth on projects with long development cycles to develop technology that lasts for decades? If nimble competitors emerge with commercially produced platforms, the tried-and-true approach will no longer work. In such circumstances, companies need to think about product lines — as opposed to programs — that don’t carry all the regulatory and compliance overhead.

“You’re talking also about a business model where there would be more investment ahead of demand to create a product line,” Fischer says. This idea is even more compelling as U.S. companies seek to compete internationally against manufacturers that have a much lower cost structure.

As executives ponder their next moves, the industry’s largest customer, the Defense Department, continues to get slammed by Congress for its byzantine procurement system that rewards incumbent contractors and deters commercial players. Arguably the Pentagon’s own behavior gives defense companies few incentives to change. Will market forces finally force their hand?

Topics: Acquisition Programs, Defense Watch, Industrial Base