2013 Defense Industry Perspective
published December 13, 2012 | by Dr. Erich Fischer and Marty Bollinger
The industry faces a once-in-a-generation inflection point, as military procurement realigns around new technologies and upstart product lines.
The 20-year experiment with a pure-play defense industry is likely coming to an end. Once every two to four decades, the industry undergoes a major transformation. The development of a formalized multisector industrial base in World War II and the consolidation into dedicated defense integrators in the 1990s are two examples.
Today’s declining budgets and changing customer requirements, and the increasing success of nontraditional competitors such as Cisco, Eurocopter, and even Boeing Commercial Airplanes signal that the industry’s status quo is likely untenable. Some portions of the sector may become more stable by spanning defense and commercial applications, while others may be more viable as arsenals or national champions, where there is only one competitor per segment.
Given that such inflection points happen perhaps once or twice in a typical career, management teams in place today have a particular challenge: to lead their companies through an environment that few in their organizations have experienced. Indeed, few leaders may have been in management positions during the last industry inflection point.
With the cost structure of the industrial base unsustainable, and with valuations nearing probable lows, 2013 will be an interesting year for both organic and inorganic transformations. The recipe for success in this type of environment can be distilled into a single imperative: manage the company as a business rather than as a collection of programs.
We offer below a summary of our thoughts for success in the defense sector over the coming year—specific challenges and specific prescriptions for how best to address them.
As we write this in late 2012, there has already been a huge decline in the U.S. defense budget for Procurement and Research, Development, Test & Evaluation—one-third lower than its peak. This drop-off over the past few years has been mirrored in many other countries. Given the lag between budgets and outlays, some companies may still feel insulated from the decline. But tackling the fiscal situation—both in the U.S. and globally—will require that defense spending be reduced further. Although we expect the decline to be less severe than in the last two downturns—when U.S. acquisition funding declined roughly 50 percent from previous peaks—there are more cuts to come.
This means that the primary mechanism for shareholder value creation by most defense companies over the past decade—growth in an expanding market—is no longer available. This new reality applies to both hardware-centric and services-centric companies. Creating value will require alternative methods, some of which will be understandably unfamiliar to current management teams, given the length of time that has elapsed since the industry as a whole invoked these methods.
The spending decline also means that capacity—a lot of capacity—has to come out to keep programs even moderately affordable. In the last U.S. downturn, from 1988 to 1995, capacity was reduced significantly across many segments, including, for example, fixed-wing aircraft (approximately 20 percent of production square footage). This was how companies managed to maintain their customers’ buying power as well as create shareholder value. In fact, 30 large industrial companies exited the defense business during the last downturn.
We are more than 20 years past the end of the Cold War, yet many defense company capabilities are still built around the extreme customer intimacy and exquisite point-solution systems development that characterized the Cold War era. Today, many threats are less predictable and tend to evolve more rapidly. This shift has raised questions about whether the capabilities systems of the typical defense company are obsolete. Defense companies need faster development and fielding cycles to remain relevant for large portions of their core markets.
Nontraditional companies—Accenture, Airbus, Apple, Cisco, Dell, Eurocopter, and Pilatus, among others—have become increasingly successful in the defense sector. Indeed, if you exclude Cold War–era systems, these types of companies account for about 40 percent of U.S. acquisition spending today for major hardware programs; services spending is similarly split.
Traditional defense companies, which are sometimes slower to deliver and more expensive, have had difficulties competing against these new competitors, even in traditional “core” markets. These traditional companies will need to determine whether they can compete in their core markets without development of commercial-like capabilities and, if not, how commercial-like capabilities can coexist with traditional defense capabilities.
Today, much of Wall Street is treating the defense sector like an industry in irreversible decline, and recommending that defense companies forget about growth and focus on maximizing dividends. This investor mind-set has been reinforced by share buybacks and dividend yields that in some cases rival those of utilities and tobacco companies—with the implicit message that there is little rationale for internal strategic investment.
Some of the sector has painted itself into a corner by setting shareholder expectations for continued high dividend yields, rather than making the case for alternative methods of creating shareholder value, such as investment in repositioning, consolidation, and perhaps opportunities in commercial-like near-adjacencies. The sector will want to build confidence in the investment community that strategic investment can create strong risk-adjusted returns. Given the opening, companies for which defense is only a portion of their business may decide to disruptively invest in the sector.
The defense sector does not have a value proposition for attracting and retaining the best talent. At the same time, some of the skills required to compete in the current and future environment are quite different from those resident in defense companies today. During the past 10 years, some of the business skills that characterized successful companies in the last downturn appear to have atrophied.
Given these five challenges, how should the sector respond? We believe that the following five prescriptions—although not exhaustive—will help companies position themselves in 2013 for success through the current downturn and beyond.
It is often said that strategy is more important during a downturn, given that the lack of a rising tide of sector growth makes it more challenging to present an attractive picture to the investment community. As we look at industry participants today, some are “hunkering down” and others appear to have a somewhat fragmented strategic focus, leading to dilution of organizational effort and, in some cases, confusion in the investor base.
It is best not to dilute effort by trying to execute too many strategies and business models, and don’t hunker down to wait for the customer to steer you in the right direction. In the last downturn, companies that hunkered down fared worst, and usually ended up exiting the sector.
Do pick one value creation strategy (or very few), and focus the company and investment community in this direction. The good news is that there are a number of potentially attractive value-creation strategies possible today, many of which have a proven track record. For example, during the last downturn, companies like Northrop Grumman and Lockheed Martin (or their forebears) created significant value by consolidating excess capacity; similarly, General Dynamics created value by recycling assets across segments.
The optimal strategy (or strategies) will vary by company situation, capabilities, and segments served, and may also vary by business unit. Management will want to choose, and choose quickly; we expect that large strategic moves could begin in 2013, as perhaps previewed by the attempted BAE–EADS merger.
An industry inflection point is a catalyst to shift a company’s strategy and—equally important—the capabilities that support the strategy. Don’t wait to identify those capabilities that matter, and don’t spread the effort too thin by trying to be “world-class” at everything you do. Given your chosen value-creation strategy, do consider which few capabilities will truly differentiate your company.
As an example, investing in commercial capabilities—fixed-price development, product-line management, and value-based pricing, among others—can help address evolving customer requirements like the demand for increasing speed of development and fielding. This will put the company in a good position to serve not only the core business but near-adjacencies as well.
Boeing is one company that has recognized this. Two of its largest military programs sell modified versions of commercial aircraft to the U.S. Defense Department: the 767-based tanker (to the Air Force) and the 737-based P-8 (to the Navy). Boeing has also acquired a number of companies that make disruptive systems, such as unmanned aerial vehicles. Collectively, these actions have enabled Boeing to compete in the defense sector more affordably and nimbly than some of its competitors.
The defense sector is undergoing the kind of correction that happens once every 20 or 30 years. It is hard to overstate the extent of the downturn. At some defense companies, however, wishful thinking persists. Some believe they will find the fast-moving stream in this otherwise stagnant water. But there is no fast-moving stream. The market is already down by a third in terms of acquisition dollars, even before a possible sequestration. Costs must be cut.
But don’t get mired in focusing on the “wrong” costs. Areas such as discretionary spending and IR&D are important to address, and can provide near-term relief, but they will reduce costs only by a few percentage points—far below what is needed. Also, avoid loading the base with marginal work—it only dilutes the enterprise’s focus and makes it more difficult to transform cost structure in the long run.
Do reduce capacity by focusing on structural and systemic costs such as facilities and the expenses associated with them (such as direct and indirect labor and supplier networks). Doing so will require painful decisions, but without it, there is no real future for portions of the sector—for customer or company. Finally, reinvest some of the proceeds in capabilities that will differentiate you for future growth, as discussed above.
In growth markets, it is often helpful to move decision making closer to the front line, where managers have the most direct contact with the day-to-day needs of customers. In a downturn, though, decision making needs to be more centralized and more direct, in part because difficult decisions will be required and “self-amputation” is an unnatural act.
Don’t underestimate the challenge that the current environment brings. Among the biggest regrets of leadership during the last downturn were not acting quickly enough and not making hard personnel decisions early.
Rethink the role of the corporate core in order to elevate decision authority, and define clearly the value that corporate headquarters provides across the enterprise. It will also be important for the C-suite to take a more direct role in the day-to-day business of the company, notably attacking costs and changing personnel who are not suited to managing through a downturn.
Much of the defense sector over the past two or three decades has been program-centric. That is, the customer—to a large extent—has acquired programs rather than products, and thus companies have tended to evolve into portfolios of programs. Given such an environment, the best program managers have logically advanced to senior leadership positions.
Although this has served the industry reasonably well when program execution has been the coin of the realm, it has not necessarily rewarded distinctive business leadership skills. Across much of the sector, the concept of the general manager (as opposed to the program manager) has declined, although this is less true in multi-industry companies than in pure defense companies.
The same leadership skills that have characterized success over the past decade or two will not necessarily apply during a downturn. In a period of industry contraction, business leadership skills are at least as important as—if not more important than—program management skills. In fact, this is an opportunity to create a new value proposition for attracting and retaining distinctive talent.
The coming year will be important for the sector to ensure customer capability and a healthy sustainability for the future. The operating models, capabilities, and leadership approaches that have worked over the past years will need to shift if companies are to reposition themselves well. Certainly, customer and industry will have to work together to achieve this. For both sides, higher levels of agility, fortitude around cost controls, and innovative thinking regarding new bases of competition will be fundamental underpinnings for a successful future.
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