Defense 2016: A Year of Big Decisions
By Sandra I. Erwin
The defense industry is bracing for another year of tough business decisions and dicey balancing acts.
With more clarity about projected military spending by the United States over the next two years, defense contractors are poised to make some bold moves to shore up their business and secure new deals, analysts predict. A change in administration looms large but companies can ill afford a wait-and-see attitude with shareholders ratcheting up the pressure to deliver short-term financial returns.
“I don’t sense that industry is sitting around,” says defense and aerospace industry consultant Kerry Millar, of Deloitte. Companies are “very focused on getting things done knowing that there will be a change in the White House,” he says. “But there is a long runway next year before the election” and executives feel a sense of urgency to go after programs and work to deliver on the programs they’ve already won.”
These tactical concerns will have to be balanced against longer term issues affecting all government contractors, such as a continued squeeze on federal spending and a growing innovation gap.
There is almost universal agreement in the United States that the world is becoming more dangerous. Conflict continues to rage in the Middle East, Russia shows no sign of easing its aggressive stance, and China’s military buildup continues to unnerve the Pentagon. The lack of an explicit military game plan for combating emergent threats, meanwhile, has left the defense sector unsure about how to position for the future.
Top Pentagon contractors in recent years have opted to cut back on research and technology development and redirect their cash reserves to stock purchases and dividend payouts — moves that have been cheered by Wall Street but have drawn jeers from Defense Department leaders. The issue has created an environment of finger-pointing as industry executives blame government obliviousness to how the capital markets work — in addition to political gridlock on Capitol Hill — for discouraging the private sector. Pentagon officials meanwhile have called out the industry for putting corporate profits ahead of national security.
The tension is likely to escalate at least until contractors are ready to make long-term bets, and this might not happen until the next administration sets new strategic priorities for the military that will shape budgets into the next decade.
R&D spending is falling both on the government and industry sides, says John Coykendall, a Deloitte aerospace and defense consultant. “Everyone is under tremendous cost pressures, under pressure from stockholders to deliver improving margins and stock price performance,” he says. “What’s gotten squeezed is money being spent in the traditional ways, funding engineering organizations to go off and design new products.”
The clash between what analysts describe as the Jack Northrop and the Jack Welch worldviews already has reshaped the industry and there is no telling where it will lead.
Investment Dilemmas
The industry’s “core strategy” of boosting stock prices by returning cash to shareholders and holding back on R&D investment may be sustainable for the next 18 to 24 months, after which companies may have to reassess their options, says Pierre Chao, of Renaissance Strategic Advisors. There is a chance the Defense Department could introduce new procurement reform measures that may undermine the industry’s current strategy by discouraging share buybacks, Chao says during a panel discussion at the Center for Strategic and International Studies.
The idea that defense contractors’ financial practices are to blame for the Pentagon’s innovation shortfalls ignores economic realities, he says. “There is a misconception of what the big guys are supposed to do. Big guys are not traditionally the sources of raw technology.” Prime contractors often wait for the innovation to come from small tech companies and then move to acquire them.
The question for defense CEOs is whether their companies can survive in the long term as “pure play” military contractors. Being entirely dependent on the government severely restricts a company’s access to capital, Chao says. “You can’t get the debt financing that is more accessible to the larger innovation economy.”
Among the few sources of cash available for defense-centric companies, other than government contracts, are angel investors who understand the defense market, a handful of venture capitalists who are still bullish on government work, or the spin off of parts of their business.
Chao points out that the defense market today offers scant incentive to put money into independent research and development, or IRAD. The calculus in the past has been to “take it on the chin” on low-margin R&D work on the assumption that double-digit profits would come later in production deals. That approach no longer works as there are fewer programs to bid for. The recent Air Force award of a $21 billion R&D contract for a new long-range strike bomber is a once-in-a-generation opportunity, as was the joint strike fighter two decades ago. This creates huge dilemmas for companies that have to figure out how to play in a market with declining high-margin hardware contracts and more low-margin services.
In today's defense market, companies see few places to put IRAD and at the same time they are compelled to cut cost to compete more aggressively. That is difficult to do when a company must maintain the infrastructure to be a defense contractor, Chao says. These demands are going to motivate companies to consolidate and grow larger to gain economies of scale.
Mid-tier contractors in the $50 million to $3 billion range are facing the brunt of this, he says. “They need to attract capital.”
The industry is going to have to adapt, Chao says. “You’re seeing a rotation in investors.” The dividend investors who expect a return of cash may give way to value investors who will demand growth. “That is the view of the Street,” he says. “With a budget deal, defense spending hitting bottom, value guys are starting to back away and the growth guys are coming back. That’s what we look forward to in the next two to three years.”
Frank Finelli, managing director of the private equity firm The Carlyle Group, warns that the income oriented strategy, although very effective, is riding into headwinds. He notes that only seven U.S. companies have $10 billion or more a year in defense revenues — Boeing, BAE Systems, Lockheed Martin, Northrop Grumman, General Dynamics, L3 and Raytheon. Four years ago, buying a share in each one was $385. The price is now $960. “The price earnings multiple has doubled. That’s really what’s indicative of the success of the income oriented strategy.” Defense industry has provided compelling investment opportunities but the bad news is that balance sheets are inefficient, and the return on equity is low, Finelli says at the CSIS panel. “The addressable market for contractors is becoming tighter.” One reason is that the Defense Department is eating up more of its discretionary funding” and consequently will be spending less on new equipment. The industry’s investor base may seek other alternatives as interest rates rise. “What investor comes in to replace them? Stocks are too high for value investors. And growth investors need to see growth.”
Here’s the fundamental challenge for CEOs, Finelli says, “How to attract new classes of investors.” CEOs have sought to increase revenue from existing programs, invest in IRAD to create new programs and markets, reduce cost and increase margins. “A lot already has occurred,” says Finelli. Mergers and acquisitions are the next available option to bring in new revenue and fresh technology.
Finding New Markets
Defense contractor BAE Systems struck up partnerships with Intelligent Textiles, Denchi Power, and Cynetic Designs to develop new methods to reduce the weight and increase the performance of batteries used by the U.S. military. The merging of disparate sectors like e-textiles, conformable batteries and wireless chargers to create a military product is one example of how defense industry can innovate and tap into commercial investment, says a recent Deloitte study. “The four companies are leveraging their own shared investment as well as those by their individual governments in each of their respective emerging technologies.”
Another case in point is a collaboration between Safran and Albany International to develop new fan blades and casings for jet engines. One of the most talked about corporate combinations in recent months was Raytheon’s controlling investment in the commercial cyber security company Websense. “This $1.6 billion investment can’t be classified as IRAD, but Raytheon’s intentions are clear: pursue growth in commercial markets, while also delivering new levels of innovation,” the study says.
The industry has to become more aggressive about nontraditional partnerships, says Coykendall, who co-wrote the Deloitte report. Some areas to watch are chemical and specialty metals. “There is huge focus on advanced materials,” he says. “Companies that develop base materials are looking for industries that can apply those materials.” Aerospace and defense companies are “always looking for ways to improve protection, durability, reduce weight and energy consumption. I think you’ll there’ll be logical connection points between those industry groups.”
New industrial “ecosystems” will emerge, says Coykendall, such as the blending of traditional and digital manufacturing. Under monikers like “Internet of things,” Internet for manufacturing and “manufacturing 4.0,” he says, companies are going to bring together the physical and digital worlds in ways that have not yet been imagined.
Companies that are not traditional aerospace and defense contractors have technologies that the Pentagon seeks, but procurement red tape has been a deterrent. “They probably don’t want to share their intellectual property or disclose all their cost information,” Coykendall says. “If the government is open to purchasing products on a commercial basis, I think there’s a lot of opportunity.”
The Pentagon reimburses contractors about $3 billion a year for IRAD expenses, but needs to come up with other ways to motivate the private sector to invest their own money, he says. The much publicized outreach to Silicon Valley is “more of a response to a feeling that the defense sector is not investing their own money in IRAD.” But companies need incentives to take money out of profits to fund IRAD. “You’ve got to give them some confidence that they’re going to be able to recoup that, or hold on to the intellectual property,” he says. In Silicon Valley, that’s the “biggest thing companies are worried about: their proprietary information.”
Size Matters
Financial pressures and changes in the government market will spark a new wave of industry consolidations, says Jean Stack, managing director of aerospace and defense, Houlihan Lokey. “What we see is a massive reshaping of the industry,” Stack says during a Bloomberg Government conference call. She estimates about $15 billion in deals is sitting on the market right now. “M&A is a good way to reposition when you don’t see a whole lot of growth,” she says. “What we’ll see I think is a resurgence of companies in the defense space interested in selling.”
After seven years of defense cutbacks, there is now a sense of optimism that military spending is reaching the bottom. “As a defense company, you don’t want to sell when the market is declining.” Defense industry sellers are saying, “We have a nice window to think about selling once we see a return to growth.”
Despite warnings by Pentagon officials that they want to see the industry invest more money in technology and would not support mergers of prime contractors, companies have to worry about not “spooking investors,” she says. “I think you’d have a lot more investment in that space with the appropriate rewards like higher margins and long-term contracts coming from R&D investments. Now there is no incentive to invest.”
After the post-Cold War wave of industry mergers, the Pentagon learned a hard lesson, says former Defense Secretary William Perry, who was in charge of the Pentagon during the rapid shrinkage of the industry in the early 1990s. He calls that wave of mergers and acquisitions an “undesirable” consolidation because it reduced competition in the market and contributed to the rising cost of weapon systems. “We would have been better off with more smaller firms than a few large ones.”
Undersecretary of Defense for Acquisition, Technology and Logistics Frank Kendall publicly chided the acquisition last fall of Sikorsky Aircraft by Lockheed Martin Corp., and has suggested that he will propose new legislation to give the Pentagon greater authority to block future deals. "Lockheed’s acquisition of Sikorsky was one of the more inventive deals of the year,” says Bloomberg Intelligence analyst Nick Taborek. “Consolidation will continue,” he says, as investors so far have responded positively to recent transactions.
Doing Things Differently
Defense officials have been beating the drum about their new approach to modernizing the military — an emphasis on “portfolios” of technologies rather than traditional weapon programs. The industry is still seeking more clarity on what this means and how it will shape future contracts.
One thing that is crystal clear is that the Pentagon is searching for ways to save money. “We need concepts for using the tools we have,” says Jamie Morin, director of the Defense Department’s cost assessment and program evaluation office. Portfolios are broad categories of systems — electronic warfare, power projection, space, missile defense, cyber security, air and undersea superiority — that are shaping the Pentagon’s 2017-2020 spending plan.
The industry tends to think about “stuff,” Morin tells a Washington audience at the Center for a New American Security. “It’s critical to think as a portfolio,” he says. “Take existing capital investments we have and use them differently or augment them. Do something in a different way. Then we can look at radical innovation.”
Much of the innovation the Pentagon wants will come from the combination of military-unique systems and cutting-edge commercial technology. How to go about blending both worlds remains the subject of contentious debate, particularly on the issue of whether the Pentagon will lower the regulatory barriers that today keep commercial companies out of the defense market.
“The potential for collaboration with Silicon Valley is there,” says Michèle Flournoy, former undersecretary of defense and CEO of the Center for a New American Security. “There has to be a business case, especially for the more innovative companies, to work with the U.S. government,” she says. “We need trained people who know how to work with this part of the economy.”
Defense CEOs say they support the Pentagon’s innovation efforts but question the government’s financial commitment.
"Clearly there's a serious mismatch between the national security threat environment and the resources we're devoting to defense," says David Melcher, president and CEO of the Aerospace Industries Association. "The massive 10-year Budget Control Act and defense cuts came prior to the rise of ISIS, before Russia's aggressive moves in Eastern Europe, and China's heating up tensions in the South China Sea,” he says during AIA’s year-end review in December. "We remain concerned that the Pentagon may allocate a smaller share in the FY17 budget request to procurement and research and development.”
The fiscal year 2016 budget the president signed Dec. 18 was greeted as good news for the Department of Defense. The $514.1 billion base budget with an additional $58.6 billion for overseas contingency operations funding — a total of $572.7 billion — is close to the president’s original February request of $577.8 billion.
The trouble for contractors is that a growing defense budget is no assurance that more money will be spent on weapon systems or contractor-provided services. Rising personnel, healthcare and deployment-related costs will squeeze procurement, research and development accounts.
“We are still going to face declining defense budgets for acquisition,” former Defense Secretary Perry tells reporters.
He cast doubt on the future of major acquisition programs like the long-range strike bomber. As procurement spending comes under pressure, the “system stimulates growth, and contractors are encouraged to promise more than they can deliver,” Perry says. The Pentagon’s motivation to “offset” the advances achieved by adversaries should be less about breakthroughs in technology and more about trying to save money, he says. “The traditional offset is using technology to gain an advantage.” Today, “I interpret the advantage as one that would offset the decreasing funds available for acquisitions. If I were the secretary that is the reason I would be doing it.”
Procurement Reforms
What actions the Pentagon might take in the coming year to incentivize contractors is a question looming large across the industry. Specifically, contractors will be watching regulatory moves in areas like procurement of commercial products and intellectual property rights.
“DoD still has a lot of work to do to solve these concerns about acquisition," says retired Lt. Gen. Charles R. “CR” Davis, a former military deputy to the assistant secretary of the Air Force for acquisition.
The Pentagon released a new study that shows improved performance in major weapon acquisitions. That is “some very good data, but I see nothing in any of the bills or any of the policy letters that solves the issue of going after innovative commercial items,” Davis says. “If DoD is serious about access to commercial technology, it has done absolutely nothing to solve that problem to the level that needs to be solved. That’s going to be the next big challenge.”
The Defense Department has begun to study how to implement the requirements of six sections of the 2016 National Defense Authorization Act that seek to lower current barriers to the procurement of commercial technology. The new measures deal with controversial issues such as evaluating the “price reasonableness” of commercial items, determinations of what qualifies as a commercial item under DoD-funded contracts and whether the Pentagon should require contractors to disclose internal cost data.
The NDAA language sets the right tone, Davis says, but he doubts the legislation can do much to change the Pentagon's deeply entrenched contracting methods. Commercial procurement means the Defense Department will have to pay market prices for something it wants even If it has a 40 percent profit margin built into it. “That’s the kind of discussion that is going to have to happen. You can’t do that for everything. But if you’re truly going to go after these innovative technologies, that’s the only way you’ll be able to approach it.”
Procurement officials understandably worry about overpaying for products and triggering inspector general investigations, but the Pentagon is going to have to strike a balance, Davis says. “When the DoD decides it needs something that is going to be important to the war fighter, it’s going to have to have discretion to be able to buy that,” he says. “Some of these things that we protected for decades — certified cost and pricing data, fair and open competition — are going to have to be dealt with,” Davis says. “Access to cutting-edge technology is not going to happen as long as you have to require cost and pricing data, data rights, and fair and open competition in everything you buy.”
Until these larger issues are solved, he adds, “We’ll continue to have these hollow discussions about going to Silicon Valley for innovative commercial technology while nothing in the process is changing. We have to be honest about which way we’re going to go.”
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