The Defense Downturn: View From A Mid-Tier Player

The defense and aerospace industry is heading into its fourth downturn of the past half century. In some respects, this downturn appears to be mirroring those that came before. After every major conflict defense spending has declined by an average of 35 percent peak-to-trough. Sequestration, which proposes to cut $1 trillion from defense spending over the next nine years, will pretty much put the defense budget at the historic reduction level. In some fundamental ways, however, this new downturn will be different from its predecessors. This is the first downturn to take place in the absence of an existential threat to the United States’ security. It is the first to occur in an environment in which the U.S. appears to be a nation in decline industrially and fiscally. It is also the first in which the revolution in the most critical technologies with military applications is coming from the private sector.

There has been a great deal of public discussion of the implications of the current reduction in defense spending for the defense and aerospace industrial base. Most of this has focused on major programs and on the big defense companies, the so-called primes. Relatively little has been heard to date from those below the prime level, particularly the mid-tier companies that provide the nation with a wealth of critical skills, capabilities and products.

So it is particularly interesting to hear from the president of one of the leading mid-tier companies. Last week, the Atlantic Council launched its new speaker series, “Captains of Industry.” The first speaker in this series was the CEO of Exelis, David Melcher, who retired as a Lieutenant General from the U.S. Army. Exelis, spun off from ITT two years ago, is a world leader in a number of areas including electronic warfare, ISR, night vision systems, military networks and composite aero structures. With revenues of more than $5 billion, Exelis is truly representative of the mid-tier defense and high tech companies that have been absolutely critical to U.S. military superiority for better than sixty years. This means that Mr. Melcher is extremely well qualified to speak on how the mid-tier companies perceive and are responding to the challenges they face doing business with the Pentagon in an age of austerity.

In his well-structured and concise remarks, Mr. Melcher laid out the challenges facing virtually all defense companies – budget uncertainty, relentless competition, a difficult customer, rapidly changing technologies and intensifying competition for scarce corporate resources. He observed that many companies, including Exelis, have responded to these challenges by a mixed strategy involving squeezing costs out of their existing businesses, rationalizing their portfolios, seeking adjacent markets, spinning off entire new companies (which is how Exelis came to be) and using spare capital for stock buybacks and enhanced dividend payouts.

More intriguing, Mr. Melcher’s remarks foresaw a time, as early as 2015, when such strategies would not be sufficient. At that point, if sequestration continues, both the private sector and the government would have to pursue new strategies. In particular, there would have to be significant consolidation in the sector. As he noted, one reason many companies are using so much of their available cash for stock buybacks or dividend payments is because they are not pursuing mergers and acquisitions. But the time is coming when there will not be shares left to buy and defense budgets will have declined so far that consolidation of the defense industry will make sense. Exelis appears poised to become a much more central player in the defense and aerospace sector when the consolidation happens.

The Department of Defense will need to prepare for the inevitable consolidation resulting from deep, even draconian defense budget cuts. This means having to accept the likelihood that there will be only a handful of companies able to perform on very complex, high tech programs. It also means that the government will have to make liberalization of export controls and the reduction in corporate tax rates matters of national security.