Resetting growth in the defense industry: Winning through a focused capabilities-based approach

Organic growth has become significantly harder for defense companies recently. However we believe it is still possible if companies adopt a capabilities-driven approach — focusing on what they are great at as an enterprise and seeking customers that will see value in their strengths.

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Resetting growth in the defense industry Winning through a focused capabilities-based approach


DC Joseph Martin Partner +1-703-682-5720 joseph.martin Joshua Harris Principal +1-703-682-5630 joshua.l.harris Hunter Hohlt Principal +1-703-682-5768 hunter.hohlt

Florham Park Randy Starr Partner +1-973-410-7604 randy.starr

Los Angeles Jim Adams Partner +1-424-294-3735 jim.adams Jono Anderson Partner +1-424-294-3736 jono.anderson



About the authors

Joshua Harris is a principal with Strategy& based in DC. He specializes in the aerospace and defense industry, with a focus on corporate and business unit strategy including mergers and acquisitions and portfolio strategy. Randy Starr is a partner with Strategy& based in Florham Park, N.J. He leads the firm’s global aerospace and defense practice and focuses on enterprise strategy and strategy-based transformations. Chris Jones is a senior associate with Strategy& based in DC. He specializes in the aerospace and defense industry, with a focus on corporate and business unit strategy including growth strategy and new market entry.



Executive summary

Organic growth has become significantly harder for defense companies recently, as governments face fiscal pressure to reduce spending and new market entrants offer commercial solutions that are often good enough, at far lower prices. In response, defense companies have sought to create value primarily through financial engineering, such as dividend policies and share buybacks — a strategy that works in the short term but is ultimately unsustainable. However, we believe that organic growth is still possible in the defense industry if companies adopt the right approach. Most of their current efforts are still centered on developing advanced technologies and then attempting to sell them to the widest possible customer base; this approach is problematic in that companies often pursue markets they do not thoroughly understand, and/or they try to sell products and services that are poorly defined or too complex for the new target customer. Instead, we recommend an approach based on a coherent capability focus. Defense companies need to focus on what they are great at as an enterprise and seek customers that will see value in their strengths. Specifically, a capabilities-based approach to growth leads to four specific avenues: (1) focus on the core, meaning a more refined approach to current markets and solutions; (2) innovate by developing new products and solutions for existing customers; (3) expand by identifying new markets for existing products; (4) diversify through new products and new markets. Critically, any of these four can work, provided that companies start with a clear understanding of their core capabilities — the things that they are good at and that truly differentiate them from the competition. Through such a capabilitiesbased approach, defense companies can generate high-margin growth and create a virtuous circle for serving both existing and new customers.




On investor calls over the past few years, a common theme has become evident: Most defense companies continue to espouse growth as the primary mechanism for long-term value creation, despite sustained pressure on, and uncertainty about, defense spending. Not surprisingly, we see very little growth actually occurring across the sector. Rightly or wrongly, capital is primarily deployed to buttress equity values in the short term (for example, through stock buybacks, dividend policies, and similar strategies) — often at the expense of investing in growth. This may be a natural response to market conditions over the past few years and to the expectations of the “value” investors that dominate the investor community for defense stocks. Equally likely is that the opportunistic and decentralized approaches to growth that worked well for the industry during the 2000s are no longer effective, and that it is better to return capital to value-seeking investors until market conditions improve. However, this activity raises the question of whether legacy defense companies can actually create value through growth in the current environment. We believe the answer is clearly yes, but it requires looking at growth opportunities through a different lens.



Historical perspective

At the end of the last defense downturn, in the 1990s, when similar market conditions existed, U.S. defense companies created significant value for shareholders. Did this value come from growth? The answer is partially yes. Companies grew during this period, but growth was a natural outcome of more ambitious strategies related to changes in the industry structure or material portfolio adjustments at the enterprise level. Many large players created value through industry consolidation, achieving profitable growth via mergers and acquisitions and removing excess capacity in the industry (such as Lockheed and Martin Marietta, Boeing and McDonnell Douglas, and others). However, the industry is already relatively concentrated, meaning the potential to create value through further consolidation is now more limited. Other companies created significant value by repositioning their portfolios. For example, General Dynamics reentered the commercial aerospace sector by acquiring Gulfstream Aerospace and placing multiple bets in the areas of C4 and IT solutions. Effectively, companies employing this strategy anticipated shifts in demand within their markets and positioned themselves for growth. Unfortunately, companies today must contend with not only future demand but also shifts in supply. Still other defense companies sought growth by diversifying outside core aerospace and defense markets and/or core products and services. But their track record was underwhelming. After countless diversification attempts ranging from telecom to book publishing, many defense companies realized that they were not equipped to compete in those markets, which were not even remotely aligned with their core business. In fact, there are few successful examples of diversification that materially improved total shareholder returns.

In the 1990s, many large players created value through industry consolidation.



A new approach for growth

Given the continued spending pressure in major defense market segments and the poor track record of defense companies in pursuing commercial markets, how can these companies grow profitably even when market conditions are not favorable? We believe it is possible, but it requires new ways of thinking about growth opportunities. Current approaches to growth by defense companies are often technology-forward. Companies develop advanced technical capabilities by serving core customers (usually on programs of record). Then they attempt to repurpose these technical capabilities to meet perceived demand from new customers in inherently attractive markets. This approach is problematic in that companies often attempt to pursue markets they do not thoroughly understand, and/or they try to sell products and services that are poorly defined or too complex for the new target customer. Instead, we recommend an approach based on capabilities. In other words, focus on what you’re great at as an enterprise and seek customers that will see value in your strengths (see Exhibit 1, next page). Although our approach seems simple and intuitive, we find that few defense companies root their analysis of growth opportunities in similar logic. In fact, many spend significant resources doing cursory assessments of new markets without an understanding or clear definition of what really underlies their success as a company (i.e., what they are great at as an enterprise). Questions typically focus almost exclusively on intrinsic elements of the market: • Which markets are growing the fastest? • Do these markets offer accretive margins? • What are the central problems that customers face? These are indeed important questions that companies must address. However, the answers tend to change fairly quickly — what is growing fast today may not be the same as what grows fast six months from now.

Focus on what you’re great at and seek customers that will see value in your strengths.



Exhibit 1 A capabilities-driven approach to growth differs in several key ways

Traditional approach
1. Develop leading technology through close relationships with core government customers 2. Identify inherently attractive markets (i.e., large, growing, and with accretive margins) 3. Apply technology to “hard problems” in inherently attractive adjacent markets
Adjacent market 1 Adjacent market 2 Adjacent market 3

Government customers


Capabilities-driven approach
1. Develop leading capabilities through close relationships with core government customers 2. Understand which capabilities differentiate you and represent your essential strengths as a company 3. Recognize adjacent markets that value your strengths 4. Apply capabilities to attractive customers in adjacent markets
Adjacent market 1

Government customers

Skills • Technology • Processes

Adjacent market 2

Adjacent market 3

Source: Strategy& analysis



The same holds true for customers’ problems; depending on the market, these problems could change by the month or even by the week (for example, in cybersecurity). Given the fluidity of these variables, companies must search out a constant. What truly makes a defense company (or any company) great usually does not change over the short or middle term in a material way. It is also rarely focused on technology alone. Rather, the foundation of a company’s success is often found in its “capabilities system,” meaning three to six distinctive capabilities that combine to differentiate the company in the market. Each capability is based on a combination of processes, tools, knowledge, skills, and organizational elements that align around meeting a desired result. The right capabilities mesh and reinforce one another, giving the company a clear and differentiated identity in the market (see Exhibit 2, next page). This is a natural place to begin when seeking growth — self-reflection to inform where to look externally. Once a company understands its unique capabilities system, then and only then should it start to explore growth opportunities, by considering questions such as the following: • What types of markets and customers would provide a good match for a company with our capabilities system? • What channels to market exist that do not require us to fundamentally change who we are as a focused defense company? Why is this approach so meaningful? The reason is that companies can drive real growth only if there is clear coherence between their capabilities systems and the markets or customers they serve. Through this approach, companies can accelerate growth and drive shareholder value with a coherent strategic framework. When analyzing the ability of companies to grow across all industries, we see a material difference in performance based on the degree of coherence that exists (see Exhibit 3, page 11). Less than 20 percent of those companies that perceive themselves as incoherent in their approaches exceed the inherent growth rate of their respective industries. Compare that to companies that are coherent, which in nearly 60 percent of cases were able to exceed average growth within their industries.

The right capabilities mesh and reinforce one another.



Exhibit 2 Sample capabilities system for a legacy defense company

A Technical ability to create solutions


(often bespoke) for “hard problems” of an individual customer or a small group of customers, due to a deep understanding of their missions, operations, or objectives

B Business development



approaches designed to serve large organizations that buy on value (as opposed to solely on price) in a centralized fashion with long lead times

C Systematic program

management capabilities tailored to deliver complex solutions with a high degree of transparency

Source: Strategy& analysis



Exhibit 3 Impact of business coherence on growth



10% 32%

48% 45%


Below industry average At industry average Above industry average

30% 18%


On the journey to coherence


Source: Strategy& analysis of survey responses from approximately 2,800 executives across industries



Do less, but do it well

Some defense companies are actually very self-aware and follow (to some degree) the process described above. They understand who they are and what they are great at, and they root their growth investment options in this logic. This is a critical first step, and these companies should be lauded. Unfortunately, even the most self-reflective and well-managed company can make the mistake of trying to do too much, an approach that actually impedes growth instead of supporting it. When we speak to companies throughout the industry, we often see a very large number of growth initiatives in place, with seemingly little impact on actual growth. Many defense companies have simultaneous initiatives under way — sometimes dozens — across multiple core defense markets, plus attempts to diversify into dissimilar commercial markets such as cybersecurity in energy and healthcare, and expansions into other countries. In fact, if you were to ask most executives in the defense industry if they are seeking to grow their core business, grow through innovation, expand their target markets, or diversify, they would answer “yes” to all of the above. Worse, they would have many “top priority” initiatives for each of those areas. Rather than having no growth priorities, they have too many — spreading the company’s attention and resources too thin at the enterprise level. And our research has found that such an approach is counterproductive and actually impedes growth (see Exhibit 4, next page). The reason is simple — pursuing too many priorities usually makes the enterprise incoherent. Each strategic growth option is rooted in its own individual logic and requires its own beliefs and theses to succeed. The competing logic and added complexity can result in subscale activities, fragmented management attention, resistance within the enterprise, and/or investments that will never pay off. This is an instance where the risk of an individual option can be high, but risks compound when multiple options are pursued; “hedging” across too many options actually increases the risk, as opposed to balancing it. In effect, absent financial engineering, this can result in returns similar to what can be achieved in the bond market with a risk profile more akin to that of private equity — which for many investors is the worst of both worlds.
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Exhibit 4 Growth of companies based on the number of enterprise priorities

16% 40%

15% 48%


18% 51%



Below industry average At industry average Above industry average

44% 37% 37% 31%


1–3 priorities

4–6 priorities

7–10 priorities

More than 10 priorities

No list of priorities

Source: Strategy& analysis of survey responses from approximately 2,800 executives across industries



Four growth options for defense companies

With an understanding of their capabilities system and willingness to focus on a small number of initiatives, companies can meaningfully evaluate viable growth avenues. At a basic level, growth opportunities can be characterized along two dimensions: market similarity and solution similarity, which leads to four specific options for defense companies (see Exhibit 5, next page). In all four options, the underlying logic is based on coherence with the company’s holistic capabilities system — as opposed to merely the best match with current product and service offerings. Focus on the core The best place to start looking for growth is in your core business, where — by default — your company already has a degree of coherence between its current market and solution and its current capabilities system. (Admittedly, many defense markets are changing rapidly, which could reduce this coherence over time.) Achieving growth in core markets effectively means taking share from existing competitors and new commercial entrants while simultaneously protecting your base business. This can be very difficult. Many companies are instead playing “defense” — hunkering down and not employing aggressive growth strategies to take share. That approach may work in the short term, but it had mixed long-term results during the last downturn. Cost controls designed to protect the base business can stall the engines that would drive growth in the eventual upswing (such as innovation and R&D). In fact, there is significant growth potential for many defense companies in their core markets. However, success in meeting the short-term requirements of investors and customers, while also positioning the company to create value in the longer term, may ultimately require material M&A (similar to the consolidation among original equipment manufacturers during the last downturn).

There is significant growth potential for many defense companies in their core markets.



Exhibit 5 Four growth options





Focus on the core

? ?
Expand target market

Existing Existing Market New

Source: Strategy& analysis



Innovate Another viable path to growth that resonates with the engineering ethos of the defense industry is to develop new solutions — i.e., to “build a better mousetrap.” This can be challenging, particularly given the current dynamics of the defense industry. Core customers are under relentless pressure to reduce spending, missions are continually evolving, and buying behaviors have shifted partially toward more commercial-like solutions at lower price points. As a result, commercial companies are taking share of core markets with tailored products that originated from focused R&D activities. The question is whether legacy defense players can keep up with the pace of innovation that exists in commercial sectors. The investments can be steep; some commercial companies invest twice as much on R&D as the top five defense contractors combined. Defense companies are not going to match this R&D spend — and they do not need to. Instead, they should focus on improving the effectiveness of R&D spending, which could make a material difference: Many defense companies waste significant capital, time, and energy on pet projects that will likely never see the light of day or generate revenue. In addition, defense companies can form partnerships with commercial firms to drive innovation. (We are already seeing this in many areas, such as Lockheed Martin’s Cyber Security Alliance or Boeing’s participation in MIT’s Leaders for Global Operations initiative.) Last, defense companies will likely need to expand their approach to innovation. It cannot be limited to better technology at any cost, but should include areas such as innovative business models, changes in how companies develop technology, and more effective market-making capabilities. (For example, a product management approach focuses on iterative design and staged infusion of new ideas from across the company. This is an improvement over the traditional program management philosophy, which is rooted in developing unique technology within the confines of an individual government program.) Expand target market The third approach to identifying growth opportunities is the one most traditionally used by defense companies: looking for new markets in which to sell their current offerings. When pursuing additional customers for existing products, many defense companies focus solely on technological sophistication. As a result, they are typically viewed as having exquisite — and very expensive — technology. Success with growing in new markets with existing solutions requires a keen understanding of who is willing to pay
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for premium solutions. Doing this well requires highly capable marketing and competitive intelligence functions, which are beyond the typical business development and communications functions that exist in the industry today. Diversify The concept of diversification almost universally generates a visceral reaction from leaders and observers of the industry. This is for good reason, as most attempts to diversify have failed (often dramatically so). A common fallacy that leads to such failures is concluding that advanced technology automatically gives the company a “right to win” in a new market. Just because you can create a solution (perhaps better than anyone else) for what you perceive as a difficult problem for new customers does not mean that they will pay a premium for it, or that you can actually operationalize the business model required to sustain this type of endeavor. Though core government customers often value the 99 percent solution, many noncore customers are unwilling to pay for more than the 80 percent solution. Furthermore, advanced technologies are often misconstrued as “products,” when they are truly more akin to R&D prototypes for which there is no established market. There is clear potential for defense companies to grow via diversification, but it is very difficult for any company in any industry to pull this off. For defense companies specifically, many may find that the changes required of the operating model are too risky to the core business.



Common requirements

We believe that profitable growth is possible for legacy defense companies across all four options. However, success in any of them hinges on three common requirements. The first is a capabilities-driven strategy, meaning a strategy rooted in an objective assessment of what you’re great at and who you are as a company. Technical capabilities are an important piece of this, but they are only one piece. More often it is the business capabilities, processes, and culture that define a company’s capabilities system. The second common element of growth is restraint. Though this may seem counterintuitive, companies can often grow more successfully by doing less. Pursuing multiple growth avenues across the enterprise that each require fundamentally different capabilities and/or operating models is costly in terms of capital, management attention, and shock to the current system. The third common element of growth is a willingness to invest in building capabilities, including business capabilities: market-based pricing, product management, global sourcing, and so on. Companies often understand this when entering new markets, but it is equally relevant when seeking growth in core markets that are changing rapidly, as with defense.

Companies can often grow more successfully by doing less.




As core defense markets stabilize after significant uncertainty and fiscal pressure, it is time for legacy defense companies to increase their attention on growth. Defense companies have been able to create value from financial engineering lately, but that approach is unsustainable over the long term. At some point, they will need to create value through business operations. By developing a better understanding of who they are and what they are good at, focusing their efforts, and investing capital in building institutional capabilities, these companies can generate profitable growth and create a virtuous circle for serving existing and new customers alike.



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