Other A&D companies are explicitly trying to establish themselves as digital leaders through M&A or partnerships. Thales has acquired Dutch-based Gemalto for more than US$5 billion, a deal that cements Thales’ new strategic vision in this sphere. Gemalto is a major player in cybersecurity products, and Thales has been on a buying binge recently to open up new revenue streams from technology. Boeing Defense, Space & Security has joined with Saab Group to build a production aircraft that provides the U.S. Air Force with a new, advanced pilot training system that could replace the T-38 in the Air Force’s T-X training program. The project is notable in that Boeing broke a norm by investing its own resources in R&D.
Some companies, such as Lockheed Martin (LM) are using venture funds to focus their long-term, strategic investments on technology innovation. LM’s fund invests in early-stage technology companies that are involved in autonomous systems and robotics, cybersecurity, artificial intelligence, advanced electronics, and sensor technologies.
No A&D company can avoid the need to be much more nimble and forward-thinking than they’ve been in the past. Companies must determine how to allocate capital to build differentiating capabilities, address current and future customer needs, help customers innovate, and, of course, maximize shareholder returns.
How can they develop an investment strategy to meet these goals? A good starting point is a more disciplined approach to valuing strategic options. This involves analyzing specific financial indicators (such as cash flows or intrinsic value) generated by the company’s current strategy, versus other strategic options. The cash flow can then be used to develop advanced products, instead of simply returning capital to shareholders. A&D companies should ensure that their approach to strategic investment decisions incorporates the following elements:
- A disciplined approach to managing capital investments as a portfolio of options, based on returns and on the drivers of intrinsic value. This includes a dynamic valuation of strategic options and trade-offs (potentially incorporating decision-tree analysis, what-if scenarios, and an analysis of real option value in a range of plausible future environments).
- Agility in the face of market uncertainty through a dynamic strategy process that is not constrained by annual financial-planning cycles.
- Reducing expenses by ruthlessly focusing on the assets, markets, business portfolio, technology, and core capabilities that provide the company’s competitive advantage. (We call this a fit-for-growth program.) Too often, R&D funds are allocated to business units, letting them decide what to do with the money, rather than earmarked to fund specific priorities.
- Incentive and compensation programs that reward executives for investment decisions that result in successful innovation and improved competitive advantage. The traditional approach of offering bonuses for meeting annual performance objectives — equity returns, earnings, and the like — is counterproductive because executives can achieve these goals while actually destroying value in the company by, for instance, seeking savings through cutbacks in R&D.
- Changes in the corporate culture. The average defense contractor’s workforce is skewed to a middle-aged demographic that is strong in developing and maintaining proprietary systems, but does not have the tech aptitude that increasingly drives weapons equipment efforts and advances today.
In those areas where commercial industries — particularly technology companies — may be several years ahead, defense contractors shouldn’t try to catch up on their own. They must realize that the government will purchase commercial products that are not proprietary in order to take advantage of their potential applications more quickly. To address this, defense contractors should partner with startups to adopt new technologies the A&D companies need. Acquisitions and venture capital–style investments are also possible in this realm. Boeing, Airbus, LM, and Raytheon have all bought interests in high-tech firms, working in areas that include cybersecurity, integrated circuits, drones, small electric airplanes, and augmented reality.