Security Studies Program Seminar
Pierre A. Chao
Senior Fellow and Director, Defense-Industrial Initiatives,
Center for Strategic and International Studies
March 2, 2005
This talk comes out of a project at the Center for Strategic and International Studies, "Strengthening the Core."
The defense industry is at the crossroads of international relations, business, and technology. Stakeholders include employees, investors, and various customers — taxpayers, the services, and Congress — and a unique external environment created by the defense budget, foreign competition, and technological change. Such a complex and fascinating industry deserves more scholarly attention than it gets.
There are fundamental disconnects in the defense industry: the primary one being the tension between public goods and private ends. Corporations want high returns and as much of a monopoly position as possible. The public wants the highest quality but cheapest possible defense. Shareholders generally reward efficiency, but the defense industry has inherently inefficient aspects. The economics may call for fewer shipyards for example, but the politics says the Navy likes six shipyards and the political support of twelve Senators they bring, for instance.
Washington , Wall Street and Main Street have different cultures. The general public generally does not understand the complexity and uncertainty inherent in military contracts. For instance, few people who read about or invest in aerospace companies understand that every successful space launch is a minor miracle.
After the Cold War ended, everyone wanted a peace dividend. Faced with shrinking defense budgets, conglomerates fled the defense industry. The services, meanwhile, tried to keep capability. Fewer programs were launched and program completion began to take longer. Customer needs were unclear. Uncertainty grew with technological and political risk. Boardrooms decided that the industry required deeper pockets to handle the volatility.
At an event dubbed Perry's Last Supper at the start of the Clinton administration, then Defense Secretary William Perry called in the leading defense industry CEOs and said that most of their companies would have to disappear. This helped spark a wave of consolidation, which was primarily horizontal ° companies buying up different capabilities.
By the mid-nineties, the remaining companies were doing well, but Wall Street wanted more. Electronics were growing in importance in the industry. For instance, 55% of the dollar value of the Aegis Destroyer is in its electronics. So the boardrooms pushed a new round of integration ° this time vertical, picking up IT and electronics suppliers. The question for government became whether the companies were becoming skilled integrators or killing competition. The peak of the wave of consolidation came when Northrop Grumman tried to merge with Lockheed Martin. The merger was blocked for fear of one firm acquiring too much of the market in defense electronics.
By the end of the 1990s, 107 firms had become five. Although most people sold their defense stock in 1992 under the assumption that "peace on earth was here", a contrarian investor who bought defense stock that year would have seen their investment grow seven fold versus a tripling of the S&P.
The 1990s were a perfect storm: technological change, a budget downturn, uncertainty, and the rise of a new business philosophy: specialization rather than conglomeration. As Norman Augustine said the record of defense industry commercial diversification is unblemished by success.
The result of the all this consolidation is a small group of defense and aerospace firms that are separate from the rest of the economy. There are three tiers of defense contractors that get about a three way split of defense contract money. The five top tier companies each have almost a full range of capabilities. There are roughly 300,000 third tier contracting companies, sheltered by Congress and small business set-asides. Some fear losing these benefits if they grow too much. The big five buy up the second tier, meaning it is being squeezed from two directions. The major companies are doing a lot of subcontracting to each other. Without second tier companies, the next tier of big players might not emerge, creating problems of competition.
Today a company needs a huge critical mass to be a major defense contractor ° about 10-15 billion of revenues. European companies have to scale up to match this. If second tier contractors do not become skilled at their niche, they get killed.
So the government got what it wanted: a handful of first tier contractors with breadth of capability. The effects of these changes are unclear.
Now let's rewind and look at this same story through a financial lens.
In the 1990s, the defense industry started to run more like a traditional business. Today the defense industry competes for investment dollars with the broader market. But it faces lower margins. Margins approached 10%, up from 6%. Now they're dropping a bit. These are low margins relative to peer industries — computer hardware, utilities, and capital goods, for example.
Conventional wisdom is that defense industry should have lower returns than peers. The reasons given usually are that the defense industry has lower risk, the Pentagon pays for "everything," R&D and assets paid for, the industry has long term contracts and the FYDP, and no one is allowed to fail.
But revenue volatility is demonstrably high. Defense spending never hits the FYDP (five year defense plan) goals. To deal with lower margins, the companies seek ways to lower their risk. There's a false sense of predictability. The government does not appreciate this.
Uncertainty and low margins make it hard to attract higher margin business. For instance, Project Bioshield, the effort to combat bioterrorism, cannot attract top biotech firms. It might make sense to allow companies higher margins.
The political impossibility of getting 10% margins means that the defense contractors constantly seek to lower their risk — keeping volatility down, spreading plants to different Congressional districts,seeking longer term contracts, and getting research and development paid for by the buyer. These are all methods of buying revenue stability.
There are several ways the industry can create value; growth (revenue), margins (return), invested capital, and competitive advantage. In the defense industry, revenue is limited by politics and budgets. Competitive advantage is disrupted by technology shifts. Firms can respond to such shifts through acquisition. Cash margins are improved by cutting investment and costs, but firms soon hit a margin glass ceiling. The amount of invested capital used is one area where firms could make hay. Thus consolidation has led to capital being stripped out of the defense industry, limiting investment. Firms have shrunk their Cold War asset base and slashed R&D spending. During the Cold War, defense firms invested 4% of their revenue in research and development. Today the figure is 1.5%. Some of this shift is explained by business shifts; IT, for example, has lower R&D costs. The question is who will do the research and development if industry will not.
So what? The "Strengthening the Core" project at CSIS asks in a way about the health of the industry. But really that is too simple a question. The industry will survive if the defense budget does. The real issue is whether the industry's survival strategies match the goals of government policymaker. The Pentagon says things are fine, but the question is whether we are missing subtle, long term problems because there is no crisis. We might be threatening our technological superiority and diminishing our capability.
Understanding the structure and dynamics of the industry helps reveal policy failures. The push to efficiency at DARPA is ill considered for example. Innovation can often be confused with waste. The Defense Department's emphasis on centralization is backwards. The way to manage complexity is decentralization.
The defense industry has a peculiar lifecycle.
It goes in four stages: science and technology (S&T), system development, produce / upgrade, and sustain / retire. Spending goes up quickly in until the production phase, and then begins to decline, achieving equilibrium in the sustain phase. Product innovation occurs first; process innovation in the later stages.
The S&T phase involves most of the product innovation. There's been a drop in S&T funding and investment in R&D. Goldwater-Nichols buried the Science and R&D post in the Pentagon hierarchy. There's not enough focus now on process innovation. Complexity threatens the management of systems and software. On the back end of the cycle, the key question is how to preserve asset intensive sectors of the industry facing low volumes (shipbuilding, space launch). Techniques appropriate in regular industries with high volumes of manufacturing° Six Sigma, lean manufacturing ° may not fully apply in the defense industry.
The relationship with the customer has changed, and different contractors have taken different approaches. Boeing does pure outsourcing and integration. Northrop Grumman and Lockheed Martin keep deeper expertise in house. Raytheon seeks vertical integration, growth from the bottom up. BAE has tried to carve out a role as global integrator but technology transfer laws make this difficult. The market and the government (the buyer) are sorting out what model is best.
Fewer buyers mean limited competition. Declines in program-starts lead to lack of sellers. Exceptions are technologies like UAVS. With all the services chasing innovation, 21 companies have emerged to provide them.
The structure of the industry depends largely on what buyers want. In peacetime, cost is the main goal. Performance and schedule take a backseat. In the Cold War, performance was key, and cost and schedule mattered less. In war, schedule matters, and performance and especially cost matter less. The notion of risk is different in each mode. The current problem is that we're caught between war and peace.
Pierre Chao is Senior Fellow and Director of Defense Industrial Initiatives at the Center for Strategic and International Studies. Before joining CSIS in 2003, he was a managing director and senior aerospace/defense analyst at Credit Suisse First Boston. In 2000, Chao was appointed to the Presidential Commission on Offsets in International Trade. He is also a guest lecturer at the National Defense University and the Defense Acquisition University.
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