When you only have one customer and that customer suddenly finds itself spending a trillion dollars more per year than it is taking in, prudence dictates you should start developing alternatives to your current business plan. That's the position the U.S. defense industry finds itself in today. Big cuts in weapons spending won't happen quickly, but at some point the combination of a deep economic recession, receding threats and Democratic Party control of the government is likely to produce a downturn in the defense business. Fortunately, the industry has many options for coping with declining demand.
The first thing companies need to do is lower expectations. The recent increases in demand had to end someday. But after investors punish defense stocks for a few weeks, it will become obvious that owning General Dynamics or Raytheon shares at a reduced rate of growth is still much more attractive than holding Dupont or Ford in the current economic environment -- or buying Treasury bills at zero interest.
The second thing defense companies can do is manage backlog better. All that demand during the Bush years has given contractors record backlogs that will take the better part of a decade to work through. Companies often tolerate excess overhead or sub-par returns in order to position for future opportunities, but once the prospect of new starts wanes, they can tighten up by cutting costs and pressuring the customer for better margins. "Mining the backlog" will allow them to maintain returns even if sales weaken.
The third thing they can do is steal market share from competitors who have failed to perform. Focused second-tier companies like Alliant Techsystems and ManTech International have the skills and flexibility to undercut bigger competitors on price and performance when affordability becomes a key discriminator. Some of the bigger companies, most notably Lockheed Martin, have also demonstrated a capacity to win business at the expense of rivals by being more responsive.
A fourth option is to expand into adjacent markets where skills developed for traditional customers may have untapped potential. Lockheed Martin is chasing a wide range of federal opportunities from logistics to healthcare to homeland security, leveraging its expertise in information systems and system integration. Boeing is bringing its commercial logistics skills to bear on military sustainment. Northrop Grumman is pursuing climate-change solutions and applying federal skills at the state and local levels.
A fifth strategy is to use cash built up in current operations to make acquisitions that fill gaps in product offerings, enhance existing competencies or bolster year-over-year results. General Dynamics has proven especially adept at deploying capital in new properties that materially improve the company's overall financial performance. As sector prospects moderate, the asking prices for many companies will fall to a point where they look like bargains for the right purchaser.
A final strategy would be to pursue a merger of equals with other companies. Most second-tier companies could implement such an approach with minimal antitrust problems. Even a big company like Raytheon might be able to merge with another defense major, since it has only modest business overlap with most platform producers. The resulting synergies could improve the competitive landscape for both partners. A merger of equals could also help defense companies gain entry to commercial markets.