DEFENSE DEPARTMENT

SPECIAL REPORT: Annual Defense Sector Report Card Shows Failing Grade

2/2/2022
By Wesley Hallman, Nick Jones and Robert Van Steenburg

Defense Dept. photo

This is part 1 of a three-part series on Vital Signs 2022: The Health and Readiness of the of the Defense Industrial Base. Click HERE to download the full report.

This year’s iteration of Vital Signs: The Health and Readiness of the Defense Industrial Base marks the third consecutive year that the National Defense Industrial Association offers an unclassified analysis of the state and performance of America’s defense industrial base as an enterprise.

Accessible to both the American public and defense policy community, Vital Signs strives to provide a comprehensive assessment of the resiliency of the defense sector by standardizing and integrating a set of criteria that reviews its performance in the context of the overall business environment.

The report frames the health of the defense industrial base as essential to economic and national security and does not examine individual companies or the Defense Department specifically, but rather the challenging business environment in which all stakeholders operate.

When researching Vital Signs, NDIA examined data relating to eight “signs” that collectively shape the performance of defense contractors. In a departure from Vital Signs 2020, this year’s report indicates a final grade of “Unsatisfactory, Failing” for the health and readiness of the defense industrial base. While technically one point short of a pass mark, specific signs provide cause for real concern.

The eight signs that collectively shaped the performance of defense contractors include: Demand, Production Inputs, Innovation, Supply Chain, Competition, Industrial Security, Political and Regulatory, and Productive Capacity and Surge Readiness. Categorized by factor, NDIA analyzed over 50 publicly available statistical indicators, converted them into an index score scaled from 0 to 100, and evaluated three years of scores for each indicator.

This year, five of the eight signs received a failing grade. This reflects the tumultuous state of the industry as it grappled with the extraordinary ramifications of the COVID-19 pandemic, which dramatically disrupted the lives of individual Americans as well as global commerce.

This past year has witnessed significant deterioration in the signs including “supply chain” as well as “production capacity and surge readiness,” which almost certainly is a result of the impact of the pandemic. Conversely, the only sign that significantly improved was “demand,” reflecting recent growth in the defense budget.

Vital Signs 2022 also reflects the story of recent political and regulatory action against adversaries and their influence over the defense industrial base, and the way in which that has shaped and will continue to shape the future of the warfighter.

As always, NDIA intends Vital Signs 2022 to be a reference document that sets forth conditions for an annual discussion on defense sector issues. It is NDIA’s hope that this report contributes to the critical debate surrounding the nation’s defense acquisition strategy by offering a common set of fact-based data points on industrial partners that give the men and women in uniform, and their civilian counterparts, an advantage in all domains of warfare.

With the exception of the survey of NDIA members fielded in August 2021, the datasets are lagging indicators. This year for the first time, it includes datasets from COVID-19. These lagging indicators provide insight into the environment in which the industrial base had to operate during the first year of the pandemic.

As a majority of the eight signs received failing grades for the first time this year, Vital Signs 2022 reveals a defense industrial base that, similar to other industries, suffered sustained losses during the COVID-19 pandemic. Six of the indicators earned composite scores lower than 80 and five of these earned scores below 70, a grade considered failing. These scores point to a defense industrial base struggling to meet the unprecedented and ongoing challenges created by the pandemic in the face of an increasing challenge from competitor nations.

Industrial Security has gained renewed prominence due to data breaches and brazen acts of economic espionage, perpetrated by both state and non-state actors, that have plagued defense contractors. However, despite the importance of industrial security, this category received a score of 50 in 2021, the lowest among the eight signs in 2022. To assess the “industrial security” sign, NDIA analyzed threat indicators to information security and intellectual property (IP) rights. The score incorporates the nonprofit MITRE Corp.’s annual average of the threat severity of new cyber vulnerabilities. This year, the analysis included the new National Institute of Standards and Technology’s 3.1 scoring system, superseding last year’s usage of the 2.7 system. Threats to IP rights scored well at 80 in 2021, as the number of FBI investigations into intellectual property violations declined to 38. This pattern marks a steady decline since investigations reached an all-time high of 235 in 2011.

Production Inputs also scored poorly in 2021, receiving a failing score of 67. These inputs encompass skilled labor, intermediate goods and services, and raw materials used to manufacture or develop end-products and services for defense consumption. In particular, the indicators for security clearance processing contributed to the low score for production inputs, as on-boarding backlogs persist.

Despite numerous negative scores, areas of confidence give cause for optimism within the industrial base. For instance, “Demand” for defense goods and services remained robust in 2021 and received an outstanding score of 94. This increase stems from a rise in contract obligations issued by the Defense Department. Moving forward, this will be an indicator to closely monitor, as the prospect of flatter defense budgets and rising inflation pose potential headwinds in the near term.

Competition last year was 88 – no decline or drop from this year – it is the same level but the area is still a strength. This high mark was driven by several high-scoring factors including a low level of market concentration for total contract awards, the low share of total contract awards received by foreign contractors, and a high level of capital expenditures in the defense industrial base.

Conversely other factors within the Competition sign experienced decreases, including a significant 11-point decrease for liquidity. These decreases were anticipated, however, due to the impact of the pandemic on the economy.

In 2021, the Innovation sign remained stagnant and received an unsatisfactory score of 69.

Scores also declined for the Political and Regulatory sign. In early 2020, prior to the onset of the pandemic, 50 percent of participants believed that defense spending is “about right,” which marked a 7 percent increase from 43 percent in 2019. This 2020 result of 50 percent is the highest percentage of “about right” responses for this question since Gallup began asking it more than 52 years ago.

“Acquisition Reform” and “budget stability,” two of NDIA’s strategic priorities, once again topped the list of concerns for industry leaders. In the Vital Signs survey, participants were asked about the most important thing government could do to help the defense industrial base.

Respondents stated that both streamlining the acquisition process, 37.6 percent, and budget stability, 27.8 percent, were paramount, which is consistent with last year’s findings.

Similarly, a vast majority, 72.3 percent, said “uncertain business conditions” when asked to cite what conditions would limit their willingness to allocate additional capacity to military production. And 62.8 percent of survey respondents cited the burden of government paperwork as a deterrent. Both findings underscore the continued importance of acquisition reform and budget stability.

The ability of the defense industrial base to expand output and fulfill increased military demand is a key test of its health and readiness. The COVID-19 pandemic, which began in early 2020, exemplifies this. In 2021, Productive Capacity and Surge Readiness earned a critical risk score of 52. This represents a 15-point decrease from 2020 and can largely be attributed to declines in output efficiency. However, it is important to note that this score is not based upon a fully mobilized economy, similar to the context of World War II. Rather, the Productive

Capacity and Surge Readiness sign is baselined against the late Cold War defense buildup, a surge of 31 percent that began during the Carter administration and accelerated throughout the Reagan presidency.

The critical impact of COVID-19 also became evident in the Supply Chain sign, which experienced an 8-point drop that is largely attributed to a worsening in cash conversion cycles for the top 100 defense contractors. Also, as indicated by our survey, workforce challenges and the availability of talent are a top concern. Interestingly, the pandemic also changed the makeup of the top 100 defense contractors, with Moderna, the maker of one of the approved COVID-19 vaccines, making it onto the list.

The health and readiness of the defense industrial base poses a challenge to the national security community. As the DIB evolves to meet new and complex challenges, Vital Signs 2022 highlights several obstacles the nation must overcome, especially in light of the continuing pandemic.

It is the hope of NDIA that Vital Signs 2022 will help inform policy discussions that lead to improvements in the health and readiness of the industrial base and a higher overall grade in Vital Signs 2023, and beyond.

Wes Hallman is senior vice president of strategy and policy, Nick Jones is director of strategy, Jeff Goldberg, director of regulatory policy, and Robbie Van Steenburg is a regulatory policy associate, at NDIA.

Part 2: 2021 Brought Another ‘Banner Year’ for OTAs

Part 3: Pentagon Struggles to Attract New Entrants Into Industrial Base

Topics: Defense Department