Changing Defense Budget Environment Drives Shift In Company Strategies
(Source: Lexington Institute; issued June 22, 2010)
Remarks by Loren B. Thompson, Ph.D., to the BB&T Capital Markets Defense Teleconference; June 22, 2010

There is only one customer that matters -- the federal government -- and that customer's behavior often diverges from what we would expect of an economic rational actor.

Some people call defense “counter-cyclical,” but a more accurate adjective might be “unpredictable.”

Most of the big game-changers in terms of demand since the defense industry first emerged in the 1950s have been surprises -- from the Korean War to the Tet Offensive to the collapse of communism to the
9-11 attacks.

So why would anyone want to operate in, or invest in, such a peculiar, unpredictable sector?

The answer is simple: the U.S. Department of Defense is the biggest purchaser of technology and technical services in the world.

It buys a billion dollars worth of goods and services every day, so any company that becomes a trusted supplier to the Pentagon potentially can tap into a vast stream of revenues.

The first decade of the new millennium has proven to be an especially lucrative period for military contractors.

Defense spending has increased from $300 billion per year to $700 billion, and America now sustains nearly half of all global military outlays.

However, at the same time defense spending was surging, our economy was losing ground, so today we find that 50 percent of global military outlays is being supported by an economy that at best generates only 25 percent of global output.

The growing disparity between our economic and military power might be tolerable if the nation were facing urgent threats from overseas, but the public's perception of danger has diminished markedly since 9-11, and thus there is good reason to believe defense outlays will begin falling in the near future.

Most of the companies in the defense sector are already preparing for a downturn, but when you only have one customer that matters and the investment community discourages diversification, options are limited.

So what I'd like to do over the next 15 minutes is look at the factors that are likely to push defense spending down during the coming decade, and then consider what key players in the sector are doing to prepare.

Let's begin by looking at the factors tending to depress defense outlays as we go forward.

Downward Pressures

Analysts often use trends in overall defense spending as a key predictor of demand for defense-industry products.

However, that approach is misleading on two counts:

-- First, the industry derives its revenues mainly from Pentagon investment accounts rather than from personnel or readiness, and the various accounts do not move in tandem.

-- Second, even the biggest military contractors claim less than five percent of the Pentagon's budget, so their fortunes are influenced more by how defense dollars are spent than by the size of the budget.

It is quite possible for industry fortunes to flag even when military spending remains high if money migrates out of technology and into manpower.

So it isn't enough to just track trends in defense spending when we try to project future demand; we have to look also at how the composition or makeup of the Pentagon budget may be changing.

With that in mind, I would offer you this simple way of looking at the downward pressures likely to impact the defense market in the coming decade:

-- First, trends external to the defense department will tend to reduce the availability of money for military purposes.

-- Second, trends internal to the defense department will tend to reduce the availability of money for the activities that are of greatest interest to industry.

In terms of the external forces driving down funding, these can be separated into three categories -- threats, politics and the economy.

Threats are a key concern because the modern defense industry came into being to help battle a particular threat posed by the Soviet Union, and the industry's future has been uncertain since that threat disappeared.

The ten years following the collapse of communism were the worst the industry had ever seen, with a hundred major weapons systems canceled in just four years while Dick Cheney was defense secretary.

Defense spending had begun to drift below three percent of GDP just before 9-11, and it’s quite possible it would have continued drifting downward had that new threat not materialized.

The industry's robust recovery since 9-11 is traceable largely to the fears engendered by the terrorist attacks, which led the Bush Administration to launch a multi-front war on terrorism that greatly increased demand for military goods.

But the absence of follow-on attacks and successful stabilization of Iraq has gradually drained away much of the urgency associated with the Bush buildup.

Our notion of who threatens us and why we are fighting is losing its focus, not to mention its political following.

As fears recede, the willingness of the political system to continue spending two billion dollars per day on defense will recede too.

That brings me to a second big external factor weighing down defense outlays, the political landscape.

Threats may be the big driver of overall defense spending, but Ron Epstein of Merrill Lynch has demonstrated convincingly that when it comes to weapons outlays, politics is decisive.

Epstein analyzed federal spending on military research and procurement over the last 50 years in light of which party controlled the government, and came to the startling conclusion that political control explained 90 percent of all the variance in weapons outlays during that time.

When Republicans controlled the White House and/or the Senate, weapons spending almost always went up; when Democrats controlled the White House and/or the Senate, it almost always went down.

Since it is highly likely Democrats will control both places through 2012, the implication is that weapons spending is headed downward.

The Obama Administration arrived in office with a very ambitious domestic agenda that required freeing up money for everything from healthcare reform to clean fuels, so it doesn't take a genius to figure out where weapons spending is headed in the absence of urgent new threats.

The third external factor impacting defense spending is the state of the economy, which has managed to produce essentially no net job growth in the current decade after achieving 20 percent gains in each of the previous two decades.

In fiscal terms, lack of economic growth translates into weak tax receipts, which limits the availability of funds for all forms of federal spending.

The federal deficit is so huge now that every day Washington must borrow an amount of money equal to the entire sales of DRS Technologies last year -- or twice the sales of ManTech.

This has become a big issue with voters, which suggests that some of the traditional support for defense spending in the electorate may be waning as people worry about whether their government benefits will be cut.

The bottom line on the three external factors I have cited -- threats, politics and the economy -- is that they are all signaling a downturn in defense spending unless some major new threat emerges unexpectedly.

Turning now to trends unfolding within the Pentagon that might reshape the composition of military spending, we can see a number of influences at work that are tending to drive dollars out of the accounts where the defense industry generates most of its revenues, and into activities beyond its reach.

The first of these is the emphasis that Secretary Gates has put on “rebalancing” the defense posture since the Obama Administration began.

Rebalancing for Gates means putting less emphasis on conventional, industrial-age warfare, and more emphasis on non-traditional skills like counter-insurgency warfare.

Gates killed or cut back dozens of major weapons programs last year in part because he thought they were ill-suited to the likely spectrum of future threats, including the Army's Future Combat System, the Navy's Zumwalt destroyer, and the Air Force's F-22 fighter.

The impact on the defense industry might not be so great if money was just shifting around within the investment accounts, but a subsidiary theme in the Gates rebalancing has been the migration of funding out of high-end technology and into people skills.

Industry has tried to meet some of the demand for people skills by offering a wider range of services, but those business lines aren't likely to generate the kinds of returns seen in hardware programs.

A second trend internal to the defense department has been the continued, seemingly inexorable growth in the cost of personnel.

The budgetary burden of military pay and benefits is growing faster than overall military spending or the inflation rate, in the process squeezing weapons expenditures out of defense budget.

Healthcare outlays alone have more than doubled in this decade to about a billion dollars per week, following the same vector seen in private-sector medical services.

Even if we exclude healthcare outlays, the average annual cost of a typical soldier or sailor in today's dollars has increased from $55,000 in the late 1990s to $80,000 today; add in the medical coverage, and the yearly cost of each service person exceeds $100,000.

If the defense budget were rising at the same rate as personnel outlays, the impact of people costs on defense industry results would be muted, but because it isn't there is less money available to buy industry products.

Which raises a third trend internal to the defense department, the move to “in-source” tens of thousands of jobs previously contracted out to industry.

Many defense companies have built up their services units during the present decade to tap into new military markets, but the Obama Administration entered office determined to restore some outsourced functions to the civil service.

The administration argues it is more cost-effective to do these tasks internally, which is almost certainly wrong over the long term.

Some of its motivation for insourcing clearly arises from the role public-employee unions play in the Democratic Party's electoral coalition.

But whatever the mix of motives may be, it is clear there will be fewer opportunities for industry to market services to the military in the future.

So from industry's viewpoint, the downward pressure exerted by external influences on Pentagon spending is being exacerbated by internal shifts in the composition of military spending.

Having watched all this unfold for some time now, industry has had plenty of time to prepare for a softening in demand.

Let's turn now to how some of the biggest players are preparing to cope with harder times.

Industry Responses

As you know, the defense industry is dominated by a handful of look-alike military conglomerates that emerged from the post-Cold War consolidation of the sector.

They are all engaged in marketing high-tech products to the same federal customer, and they share similar competencies in electronics, aerospace and information services.

When new opportunities such as cyber-security or unmanned aircraft appear, sector players tend to move as a herd to pursue the business.

So it is too with downturns -- there is a standard playbook for coping with flagging demand that includes steps such cutting expenses, combining units, mining the backlog and making acquisitions.

However, the superficial similarities of the big players mask a great deal of diversity when it comes to matters like operating culture and management talent.

So you have to look at each player individually to get a sense of how they might fare in a downturn, and what you see is that despite similarities, some are much better positioned for the hard times ahead than others.

Consider Northrop Grumman, a company that seems well-positioned in terms of its business lines and competencies, but which has struggled throughout the decade to match the performance of its industry peers.

The company's uneven results have led some analysts to characterize it as a “sleeping giant,” implying that there is a great deal of value that might be unlocked by the right management team.

I agree with that assessment, but in a period of softening demand it may be easier to unlock the value through major divestitures and portfolio reshaping rather than through organic growth.

Northrop Grumman isn't as exposed to a falloff in business from Iraq and Afghanistan as some of its competitors, but it also isn't as well positioned to cover declining domestic sales with increased overseas business.

Under pressure from a dissatisfied board of directors, the company has made a series of major changes over the past year...

-- First, it has replaced CEO Ron Sugar with the younger, more numbers-drive Wes Bush.

-- Second, it has adjusted performance metrics to stress capital efficiency over revenue growth.

-- Third, it has reduced the number of operating units by consolidating aerospace and information operations.

-- Fourth, it has divested its TASC unit due to conflicts and withdrawn from a very risky Air Force tanker bid.

-- Finally, it has announced its corporate headquarters will move from Los Angeles to the national capital region.

Collectively, these steps represent the most sweeping changes introduced by any defense major in anticipation of the coming downturn, and they hint at more changes to come.

It appears that Northrop could become a smaller, higher-quality company as the decade progresses, divesting under-performing businesses like shipbuilding while paying closer attention to shareholder expectations.

But Northrop Grumman today is a work in progress, so we will have to wait and see whether it can transform itself.

At the opposite end of the performance spectrum from Northrop Grumman is its main competitor in the shipbuilding space, General Dynamics.

Under industry legend Nick Chabraja, GD made shareholders the main focus of its business strategy for over a decade, and during much of that time it has been the preferred defense holding of many institutional investors.

GD prefers to operate as a portfolio of discrete businesses rather than as a functionally integrated enterprise, and it generally avoids chasing fads like military transformation.

Its entire focus is on generating superior financial results from quarter to quarter.

As I remarked in Business Week several years ago, “Boeing makes planes, Raytheon makes missiles, GD makes money.”

But Nick Chabraja is now departed from any visible role in the company's day-to-day management as the sector heads into a period of softening demand.

You could say that Nick already prepared the company for a downturn by defying the conventional wisdom and buying Gulfstream a decade ago.

Gulfstream’s sizable access to commercial markets will insulate GD in any downturn of domestic defense sales, as will its growing international military presence.

On the other hand, the company's Combat Systems group is exposed to a dropoff in demand from Iraq and Afghanistan, and CEO Jay Johnson has not yet proven that he can manage the company through a downturn.

My gut feeling about GD is that it will take whatever steps are required to avoid disappointing shareholders, including changing the basic character of the enterprise, because its entire culture is geared to satisfying the investment community.

Another big defense player in which I have considerable confidence is Raytheon, in part because its behavior over the last several years has increasingly seemed to emulate the bottom-line orientation of General Dynamics.

Raytheon's meticulous attention to detail at the operating level has produced impressive organic growth, especially overseas where it now generates nearly a quarter of its sales.

Recent bookings suggest that overseas sales could grow to as much as a third of the company's revenues, far surpassing the foreign military sales performance of any other major player in the sector.

All of the big defense companies say they plan to grow internationally as part of their strategy for dealing with a domestic downturn, but Raytheon has more credibility than most in being able to actually execute such a strategy.

The company has managed to avoid heavy exposure to Iraq and Afghanistan, to insourcing, to commodity IT, and to the kinds of conflicts that forced Northrop to divest TASC, so it looks more stable going forward than some peers.

Having said that, I should note that there does seem to be some softness in missile demand, and the company has repeatedly faltered in its efforts to become a bigger player in missile defense.

Also, the fact that so much of its domestic revenues are delivered as a subcontractor rather than prime contractor does introduce an element of complexity into future business prospects that is absent in the case of GD or Lockheed Martin.

But Raytheon is better run and more focused today than at any other time since the Cold War ended, so it looks like a good bet for the tough decade ahead.

I don't want to talk too long, but I can't conclude without briefly discussing the biggest player in the defense sector -- Lockheed Martin.

The problem with being the biggest player is that when the only customer that matters decides to cut spending, it's almost impossible to avoid taking a hit.

The company needs to generate $130 million in new sales every day just to stay where it is, and that won't be easy in a down market.

However, it is the dominant player in military space, tactical aircraft, naval electronics and government IT, with considerable upside potential as development programs transition to production.

It also has great potential to expand its overseas sales as programs like F-35, C-130, Aegis and Littoral Combat Ship progress.

I advise several of the biggest companies in the sector, and it appears to me that in addition to having the best business mix, Lockheed also has the deepest management bench and the strongest operating culture.

Nonetheless, management is taking several steps to prepare for the coming downturn...

-- First, it has launched an initiative to cut expenses across the enterprise.

-- Second, it is selling operations that no longer seem a good fit or face difficult business conditions.

-- Third, it is refocusing its sprawling services unit into an IT-only operation while shifting other service lines to the electronics unit.

-- And fourth, it is pursuing adjacent federal markets in healthcare, energy and other non-traditional lines.

The company has done a good job of clawing back lost market share in military space since the decade began, and it may soon find itself the sole producer of fighters and cargo planes in North America.

That all bodes well for the future, but as the biggest player in the sector it may need to take more radical steps to maintain its revenues and returns if the defense downturn proves to be deep or protracted.

I think I will stop there, and now take whatever questions you may have about military programs and priorities.


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