Defense Market Drivers & Trends Through 2012
(Source: Lexington Institute; issued May 5, 2009)
Presentation by Loren B. Thompson, Ph.D., at the Jane’s US Defense Conference
Washington, May 5, 2009

I am very pleased to be here today, sharing the stage with experts whose professional accomplishments in the defense arena greatly exceed my own.

I have been asked to spend 15 minutes discussing future demand drivers and trends in the defense market.

Given the time constraints, I will limit my remarks to the U.S. defense market during the period between now and the next presidential election.

Within that timeframe, I would like to answer three questions...

First, what are the key factors originating outside the defense department that will shape the demand for military goods and services?

Second, what are the key influences originating within the department that will shape demand?

And third, what demand trends will result when these internal and external drivers combine?

My basic conclusion will be that in the absence of some urgent new threat, U.S. defense spending will trend downward continuously over the next four years, and that the decline will be more pronounced in investment accounts than in other categories of military spending.

It doesn't take great foresight to see that coming, but since the United States currently generates nearly half of all global military spending and represents most of the demand for high-end military systems, the gradual unraveling of the Bush defense posture has profound implications for the future of the defense industry.

Let me begin my analysis of why that is so by spending five minutes on factors originating outside the defense department that will be reshaping demand over the next four years.

External Drivers

The external drivers of defense demand fall into three broad categories -- threats, politics and economics.

Although the defense industry typically pays more attention to demand drivers originating within the defense department, past experience suggests external influences have a bigger impact on the scale and composition of military demand.

For example, the emergence of the modern defense industry in the 1950s resulted mainly from the military threat posed by the Soviet Union, and when that threat disappeared, the defense industry nearly disappeared with it.

But threats are not the only external driver of defense demand, because the defense department is part of a political system that must perceive and assign significance to security concerns before they can translate into demand signals.

In addition, economic conditions will limit the range of defense options available to the political system for dealing with whatever threats it detects.

So if you want to understand how external forces will influence defense demand over the next four years, you have to analyze all three types of external drivers -- threats, politics and economics.

Unfortunately for defense contractors, each of those areas is currently in a state of flux, making reliable predictions of future market conditions nearly impossible.

In the case of threats, the defense department is dealing with an extraordinarily diverse array of conventional and unconventional dangers, with no one threat being powerful enough to serve as a central organizing principle for the whole defense posture.

Irregular warfare is the most prevalent form of combat today, but the possibility of conventional or nuclear conflict persists and a host of new threats like cyber attacks and biological terrorism have emerged.

Secretary Gates talks of the need for "balance" in much the same way that Secretary Rumsfeld used to talk about the need for a "capabilities-based" approach to planning, but the simple truth is that there is little clarity about future threats.

In the cases of the other external drivers of demand -- politics and economics -- the outlook is all too clear, with evidence pointing to a downturn in both the ability and desire to sustain a robust defense posture.

The Obama Administration was elected on a pledge to get out of Iraq, and arrived in office with the most ambitious domestic agenda since Lyndon Johnson's Great Society.

Even if we set aside the reflexive dislike of some Democrats for the defense industry, it is likely that the White House will be looking to the defense department for money to help fund its domestic initiatives, and that means continuous downward pressure on military spending throughout the next four years.

With regard to economic drivers, the news is all bad -- the U.S. economy is in a secular decline as manufacturing collapses and services contract, leaving the nation with huge trade and budget deficits at far as the eye can see.

While some amelioration of current economic conditions is likely next year, the budget deficit is expected to remain above half a trillion dollars annually throughout the next decade, and any recovery will bring an increase in trade deficits with corresponding downward pressure on the value of the dollar.

Defense planners tend to ignore such issues when formulating military requirements, but it should be obvious that the outlook for military demand is weak when...

-- Threat trends are ambiguous.
-- Political trends favor domestic spending.
-- And economic trends are eroding the tax base.

Given the kinds of threats we are facing and the priorities espoused by the new administration, we can reasonably assume that when the contraction comes it will hit personnel and readiness accounts less hard than weapons accounts.

Internal Drivers

That brings me to the drivers of future military demand that arise from within the defense department itself.

Clearly, the biggest internal driver is the longstanding commitment of the military establishment to high-tech conventional warfare, which has spawned priorities, constituencies and values that largely dictate our present defense posture.

The United States became so good at conducting conventional combat operations that it is now an article of faith among policymakers that no sane country would challenge America head-to-head in "traditional" warfare.

That belief may be misplaced, because key components of the conventional force posture such as the heavy bomber fleet have become so old that our edge over other industrial nations may not be so great as we imagine.

But with most of those other nations claiming to be our allies, the Obama Administration does not appear especially concerned with the aging of the Cold War arsenal, so conventional warfare is unlikely to generate many new program starts over the next four years.

The three internal drivers likely to have the biggest impact in reshaping demand over those years are...

-- Rising personnel costs.
-- Expansion of irregular warfare capabilities.
-- And efforts to reform business processes, including acquisition.

In the case of personnel costs, we see several different trends under way that cumulatively will squeeze other kinds of expenditures out of the defense budget...

-- First, President Obama has stuck with Bush Administration plans to increase the ground forces by 92,000 personnel.
-- Second, the cost of a typical uniformed member of the armed services has increased by about 45 percent after inflation over the past ten years.
-- Third, Congress continues to add new benefits for service members such as free college tuition and supplemental Medicare coverage.
-- Fourth, the cost of civilian defense employees is also rising faster than inflation.

As a result of these trends, the budgetary burden of personnel is rising by billions of dollars each year, and the department's financial obligations to said personnel often persist for decades after they depart public service.

One reflection of the trends is that the cost of military healthcare has risen 144% since President Bush took office, and threatens to double again during the Obama years.

Such trends go largely unnoticed in national media, because items like civilian pay and military healthcare are subsumed in the operations and maintenance accounts, where their true character is obscured.

But the bottom line is this: the cost of personnel is becoming so burdensome for the defense department that it is draining money from modernization accounts, and that process will accelerate as military spending begins declining in 2011.

The effort to incorporate greater irregular warfare capabilities into the joint force -- and assimilate the lessons of ongoing campaigns -- is a separate but overlapping demand driver likely to persist as long as Secretary Gates runs the department.

Unlike the technology-intensive defense posture that Secretary Rumsfeld was pursuing, irregular warfare is mainly about people and skills, including a wide range of skills that the department did not value highly in cold war years.

There's a lot of hardware associated with the enterprise too, but it tends to be items like body armor, radios, laptop computers and trucks.

The big system-of-systems networking initiatives that Rumsfeld will be remembered for -- programs like Space Radar and Transformational Satellite Communications -- are not really central to the counter-terror and counter-insurgent capabilities that Gates wants to bolster in the budget.

So one by one he is killing off those programs, and replacing them with things like helicopters and surveillance drones.

Gates doesn't envision a wholesale dismantling of conventional forces, but what he wants is a posture in which roughly half of the warfighters and weapons are broadly applicable to unconventional threats.

The way Gates explained the resulting force mix last Sunday was that 50% of the posture would be conventional, 10% would be unconventional, and 40% would be dual-use capabilities applicable to both kinds of challenges.

What this seems to suggest is that intelligence, training, logistics and other services will bulk larger in the future defense market, while system integration of complex networks and warfighting platforms will be less important.

There is one other big new demand driver within the defense department that will probably make industry's efforts to adapt harder than they otherwise might have been.

The Gates team isn't impressed with the way their predecessors went about framing requirements and managing programs.

It is determined to tighten up on contracting procedures and acquisition practices, fostering a less forgiving business environment for companies who fail to perform right the first time.

One consequence of this attitude is that there will be less demand for contractor personnel in the department, because Gates intends to restore and expand organic competencies in areas such as price estimation and program administration that were lost after the Cold War ended.

When the drive for greater internal expertise is combined with a reduced presence in Iraq and the natural tendency of bureaucracies to pull work in-house as budgets shrink, it seems inevitable that there will be fewer opportunities for outsourcing of defense support work during the Obama years.

The desire to tighten up business practices dovetails nicely with the biases of many Democrats in Congress and the Administration, who want to preserve civil-service jobs and don't trust market forces to discipline price or performance.

So even though services are likely to bulk larger in Pentagon purchases as hardware spending plummets in the years ahead, the outsourcing boom of the Bush years is definitely over.

The range of service opportunities may actually shrink, even as the defense customer becomes more demanding about contract conditions and performance expectations.

Demand Trends

As you can see from my remarks to this point, most of the key demand drivers at work inside and outside the defense department over the next four years will tend to depress the market for military goods and services, rather than stimulate it.

Now, it is important to recognize that this projection is based on the assumption that current conditions will persist.

We saw on 9-11 how a handful of players can completely upset all the carefully crafted plans of policymakers.

But since there is no way of knowing for sure when such catastrophes might occur -- or predicting positive developments such as the collapse of communism -- we are forced to extrapolate the future from current conditions.

So let's assume nothing much changes for the next four years, and turn to that third question I posed at the outset.

What demand trends will result when the various internal and external drivers I have described combine?

I see ten likely trends...

--First, the overall level of defense spending will trend downward over the next four years in response to unfocused threats, big budget deficits, a weak economy and an ambitious domestic agenda.

--Second, investment accounts will be hit disproportionately hard due to the military and political priorities of the Obama Administration, with personnel costs claiming an ever-increasing share of defense outlays.

--Third, within the investment accounts, there will be less emphasis on complex system-of-systems integration projects, and more stress on items suitable for waging irregular warfare like rotorcraft, trucks and surveillance drones.

--Fourth, increased spending on protection of joint-force enablers like communications networks and satellites is likely as enemies seek to target vulnerabilities in the force posture, but the scale of these new investments will be not be sufficient to compensate for the loss of program revenues in other areas.

--Fifth, although aggregate demand for services will not grow, services will comprise an increasing share of military purchases as weapons programs are deferred and the department seeks to sustain a larger ground force.

--Sixth, the mix of services that the department purchases will shift, with less money spent on support of forward-deployed forces, and more money spent extending the life of aging equipment and digitizing healthcare delivery.

--Seventh, service-life extension and upgrades of existing combat fleets will become a bigger business, partly because money for new systems will be scarce, partly because of the need to reset battle-worn equipment, and partly because next-generation programs like the Armed Reconnaissance Helicopter have faltered.

--Eighth, as the war in Iraq winds down and maintenance backlogs begin to shrink, the trend towards outsourcing of logistics functions will reverse and defense agencies will increasingly seek to in-source workloads as a way of protecting their workers and budgets.

--Ninth, faced with contraction in traditional hardware and service markets, the biggest defense companies will look to adjacencies and civil opportunities in the federal marketplace as a way of avoiding weak year-over-year results.

--Finally, the business outlook for second-tier defense companies that grew rapidly during the Bush years will weaken as larger companies invade their market turf in pursuit of a more diverse business mix, leading to a wave of consolidation in the sector that eliminates many smaller firms.

The kind of products that will fare well in the emerging defense marketplace are systems such as the V-22 Osprey and Littoral Combat Ship, because they provide the versatility to cope with both conventional and unconventional threats without busting the budget.

The kind of services that will fare well are those that bolster the irregular warfare skills of the joint force and keep aging weapons systems relevant, while not threatening the jobs of civil servants in depots and defense agencies.

And the kind of companies that will do well are large, integrated security enterprises like Lockheed Martin and Northrop Grumman, that combine diverse technology expertise with extensive services work and strong political skills.

I would be happy to expand upon these thoughts or discuss specific programs during the question and answer period.


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