2013 Defense Industry Perspective
by Dr. Erich Fischer and Marty Bollinger
Originally published by Booz & Company: December 13, 2012
The industry faces a once-in-a-generation inflection point, as military procurement realigns around new technologies and upstart product lines.
The 20-year experiment with a pure-play defense industry is likely coming to an end. Once every two to four decades, the industry undergoes a major transformation. The development of a formalized multisector industrial base in World War II and the consolidation into dedicated defense integrators in the 1990s are two examples.
Today’s declining budgets and changing customer requirements, and the increasing success of nontraditional competitors such as Cisco, Eurocopter, and even Boeing Commercial Airplanes signal that the industry’s status quo is likely untenable. Some portions of the sector may become more stable by spanning defense and commercial applications, while others may be more viable as arsenals or national champions, where there is only one competitor per segment.
Given that such inflection points happen perhaps once or twice in a typical career, management teams in place today have a particular challenge: to lead their companies through an environment that few in their organizations have experienced. Indeed, few leaders may have been in management positions during the last industry inflection point.
With the cost structure of the industrial base unsustainable, and with valuations nearing probable lows, 2013 will be an interesting year for both organic and inorganic transformations. The recipe for success in this type of environment can be distilled into a single imperative: manage the company as a business rather than as a collection of programs.
We offer below a summary of our thoughts for success in the defense sector over the coming year—specific challenges and specific prescriptions for how best to address them.
As we write this in late 2012, there has already been a huge decline in the U.S. defense budget for Procurement and Research, Development, Test & Evaluation—one-third lower than its peak. This drop-off over the past few years has been mirrored in many other countries. Given the lag between budgets and outlays, some companies may still feel insulated from the decline. But tackling the fiscal situation—both in the U.S. and globally—will require that defense spending be reduced further. Although we expect the decline to be less severe than in the last two downturns—when U.S. acquisition funding declined roughly 50 percent from previous peaks—there are more cuts to come.
This means that the primary mechanism for shareholder value creation by most defense companies over the past decade—growth in an expanding market—is no longer available. This new reality applies to both hardware-centric and services-centric companies. Creating value will require alternative methods, some of which will be understandably unfamiliar to current management teams, given the length of time that has elapsed since the industry as a whole invoked these methods.
The spending decline also means that capacity—a lot of capacity—has to come out to keep programs even moderately affordable. In the last U.S. downturn, from 1988 to 1995, capacity was reduced significantly across many segments, including, for example, fixed-wing aircraft (approximately 20 percent of production square footage). This was how companies managed to maintain their customers’ buying power as well as create shareholder value. In fact, 30 large industrial companies exited the defense business during the last downturn.
We are more than 20 years past the end of the Cold War, yet many defense company capabilities are still built around the extreme customer intimacy and exquisite point-solution systems development that characterized the Cold War era. Today, many threats are less predictable and tend to evolve more rapidly. This shift has raised questions about whether the capabilities systems of the typical defense company are obsolete. Defense companies need faster development and fielding cycles to remain relevant for large portions of their core markets.
Nontraditional companies—Accenture, Airbus, Apple, Cisco, Dell, Eurocopter, and Pilatus, among others—have become increasingly successful in the defense sector. Indeed, if you exclude Cold War–era systems, these types of companies account for about 40 percent of U.S. acquisition spending today for major hardware programs; services spending is similarly split.
Traditional defense companies, which are sometimes slower to deliver and more expensive, have had difficulties competing against these new competitors, even in traditional “core” markets. These traditional companies will need to determine whether they can compete in their core markets without development of commercial-like capabilities and, if not, how commercial-like capabilities can coexist with traditional defense capabilities.
Today, much of Wall Street is treating the defense sector like an industry in irreversible decline, and recommending that defense companies forget about growth and focus on maximizing dividends. This investor mind-set has been reinforced by share buybacks and dividend yields that in some cases rival those of utilities and tobacco companies—with the implicit message that there is little rationale for internal strategic investment.
Some of the sector has painted itself into a corner by setting shareholder expectations for continued high dividend yields, rather than making the case for alternative methods of creating shareholder value, such as investment in repositioning, consolidation, and perhaps opportunities in commercial-like near-adjacencies. The sector will want to build confidence in the investment community that strategic investment can create strong risk-adjusted returns. Given the opening, companies for which defense is only a portion of their business may decide to disruptively invest in the sector.
The defense sector does not have a value proposition for attracting and retaining the best talent. At the same time, some of the skills required to compete in the current and future environment are quite different from those resident in defense companies today. During the past 10 years, some of the business skills that characterized successful companies in the last downturn appear to have atrophied.
Given these five challenges, how should the sector respond? We believe that the following five prescriptions—although not exhaustive—will help companies position themselves in 2013 for success through the current downturn and beyond.
It is often said that strategy is more important during a downturn, given that the lack of a rising tide of sector growth makes it more challenging to present an attractive picture to the investment community. As we look at industry participants today, some are “hunkering down” and others appear to have a somewhat fragmented strategic focus, leading to dilution of organizational effort and, in some cases, confusion in the investor base.
It is best not to dilute effort by trying to execute too many strategies and business models, and don’t hunker down to wait for the customer to steer you in the right direction. In the last downturn, companies that hunkered down fared worst, and usually ended up exiting the sector.