The Defense Industry Outlook Through 2012

Remarks at Raytheon Headquarters

I’ve been asked to spend thirty minutes this morning assessing the outlook for the defense industry over the next several years — the “Obama years,” as they will probably come to known.

Thirty minutes sounds like an eternity to someone who is accustomed to talking in ten-second sound-bites, so I spent some time thinking through how I could separate my thirty minutes into relatively brief and digestible segments.

What I came up with was the idea that the outlook for the defense sector depends on three factors — threats, politics and economics — so I should spend seven or eight minutes on each of those subjects and then draw some conclusions at the end about how to prepare for the future.

Here’s how I intend to proceed…

— First, I will explain how the ebb and flow of military threats brought the defense industry to its present state.

— Then, I will analyze how President Obama and the Democratic Congress are likely to treat defense-industry programs if threats remain unchanged over the next four years.

— Next, I will assess the impact of current economic troubles on the availability of funding for defense programs.

— And finally, I will offer my conclusions about how the industry should position itself for the challenges that lie ahead.

I should say here at the outset that my gut feeling is we are headed down in defense spending during the Obama years unless some major new threat materializes.

But defense companies should be more concerned with the composition of defense spending than the scale, because America will remain by far the biggest military market in the world for the foreseeable future.

Your goal as corporate communicators should not be to keep defense spending at its present level — that probably isn’t feasible — but to promote the ideas and products that will help your company gain market share regardless of which way Pentagon spending is headed.

With that by way of introduction, let’s begin by looking at how threats drove the evolution of the defense industry to its current state.

Military Threats Drive The Defense Sector

The defense industry has been such a persistent feature of our national landscape over the last several decades that many people working in the sector probably assume it has been with us from the early days of the republic.

But it hasn’t.

In fact, the year that I was born — 1951 — it barely existed at all.

The reason why is simple: in order to have a large and dedicated defense industry there must be sustained demand for military goods, and that in turn requires widespread perceptions of a threat to national security.

For much of American history, no such danger was detected.

The nation had weak neighbors to the north and south, and fish to the east and west, so it seldom worried about external threats.

Abraham Lincoln gave a famous speech early in his career saying that the only human force that could ever destroy the republic was the inability of Americans to get along with each other, a view that came to be regarded as prophetic when the South seceded.

But young Lincoln’s speech also reveals how insulated America felt from foreign threats, for he states in the speech that all the armies of Europe, Asia and Africa combined could not in a thousand years conquer America.

That was a common view among Americans for most of the 19th Century, and as a result military spending seldom rose above one-percent of national output between the end of the War of 1812 and the outbreak of the First World War a century later.

The main exception was the Civil War, however that conflict was between Americans rather than between America and some other country.

Concern about military threats was so muted that in the nation’s centennial year, the Army’s ranks were reduced to a mere 24,000 men.

That’s 24,000 soldiers to defend a continental nation of 46 million souls.

In such circumstances, there simply wasn’t enough demand for military equipment to sustain a private-sector defense industry.

Beyond a handful of Navy shipyards and Army arsenals, the nation had no dedicated capacity for producing weapons.

The government preferred to turn to commercial manufacturers for war production when threats arose, expecting that any mobilization would be relatively brief and the economy could then return to what was called “normalcy.”

The industrial mobilization strategy didn’t work very well — none of the planes built for World War One actually made it to the front before the conflict ended — but it was a lot cheaper than buying weapons that might never be used between wars to sustain a “military-industrial complex.”

The whole pattern changed around 1950, though, because policymakers and the public became convinced that the threat of communist aggression wasn’t going to go away quickly the way fascism had.

Once the Soviet Union obtained nuclear weapons, and then ballistic missiles, the United States went on a permanent war footing and military spending surged from one or two percent of gross domestic product to ten percent.

Military outlays stayed uncharacteristically high for the next four decades even as the economy grew, claiming nine percent of GDP in the 1960s and six percent in the 1970s and 1980s.

It was this abnormally elevated and sustained level of military spending during the cold war that made the defense industry as we know it today possible.

All of the senior executives who run defense companies today came of age during the cold war, and so they tend to assume that having a big, robust defense industry is nothing out of the ordinary.

But the truth of the matter is that America got along fine without a defense industry until urgent, persistent threats to national security materialized, and if the political system ever becomes convinced those threats have gone away for good, the defense sector will go with them.

We got some sense of how that might unfold in the 1990s, when pretty much everyone came to believe that the collapse of communism heralded a prolonged period of peace.

Defense industry fortunes plummeted…

— Defense secretary Dick Cheney canceled a hundred weapons programs in four years.

— Procurement spending fell by two-thirds in inflation adjusted terms.

— The industry consolidated from 20 major players to five or six.

— And even hardliners like George W. Bush were talking about “skipping a generation of weapons.”

The absence of urgent threats in the last decade is the main reason why policymakers in both parties became interested in the notion of military transformation, because they thought there was time to take some risks and experiment with new ideas before the next big threat arose.

So they slashed military outlays and used the “peace dividend” to balance the federal budget while rethinking the nation’s defense posture.

That all came to a screeching halt on 9-11 when the “strategic pause” policymakers had been counting on disappeared overnight, and the nation plunged into a new wave of military spending.

9-11 came just in the knick of time for the defense industry, which was facing the prospect of a second straight decade of depressed demand — a decade that might very well have witnessed the demise of the sector.

Military contractors have done so well since 9-11 that the debilitated state of the defense sector when the new millennium dawned is now largely forgotten.

But the evidence of the last sixty years points clearly to the conclusion that when threats recede the defense industry declines, so the absence of any follow-on attacks since 9-11 should be viewed as a harbinger of where this sector is headed.

No threat, no defense industry — it’s almost that simple.

Now some of you may be thinking, “yes, but politics plays a big role in sustaining our revenues, and we’re a major component of the economy.”

Well fair enough, so let’s turn now to politics and the economy to see if they might offer you any refuge in a world of receding threats.

Political Trends Have Turned Against The Defense Sector

On inauguration day we will complete a presidential election cycle in which the candidates of the two major parties sounded surprisingly similar on military matters.

Senator Obama and Senator McCain both said that the nation needed to invest in better intelligence, special operations capabilities, missile defense and next-generation conventional weapons.

The two candidates also called for expanded ground forces, acquisition reform, and closer oversight of contractors.

A casual observer of the election debates might easily have concluded that there is an emerging bipartisan consensus on defense priorities, which makes the future outlook for defense demand fairly easy to predict.

However, any such conclusion would be naive — McCain would have increased defense spending, and Obama is certain to cut it.

In fact, the likelihood that the Democrats will slash defense outlays is so high that a major investment house has constructed an entire theory of defense equity performance around the question of which party controls the federal government.

Several years ago, Merrill Lynch analyst Ron Epstein commissioned a rigorous statistical study of military investment patterns over the previous 50 years, and came to the startling conclusion that whether Democrats or Republicans control the government matters more for the fortunes of the defense industry than whether threats to national security are growing or receding.

Epstein reasoned that the main driver of defense equity values was how much the Pentagon was spending on its investment accounts, meaning research, development and procurement.

So he had researchers investigate the correlation between various political, economic and security trends and the level of outlays in military investment accounts.

What he found was that when Republicans controlled the White House and the Senate, weapons investments typically increased and defense equities fared well, whereas when Democrats controlled the White House and the Senate, both weapons spending and stock prices fared poorly.

The correlation was so close that Merrill Lynch concluded about 90 percent of the variation in weapons spending was traceable to partisan control of the government.

Now, I should mention some caveats here…

— First, Merrill Lynch found little relationship between weapons spending and which party controlled the House of Representatives.

— Second, the pattern of Democratic aversion to weapons outlays was much more pronounced after the Vietnam War than before.

— And third, the two most recent Democratic presidents before Obama (Carter and Clinton) came into office right after wars had ended, so their approach to military spending was probably driven in part by receding threats.

But even with the caveats in mind, the findings of the Merrill Lynch study suggest very strongly that the Obama years will witness a major decline in weapons outlays, not only because a war may once again be ending, but because Democrats simply don’t like to spend money on weapons — they have other priorities.

On that basis, Epstein predicted that the highest likely level of outlays for weapons by a Democratic administration elected in 2008 was well below the lowest likely level for a Republican administration — with the spread between lowest likely Democratic outlays and highest likely Republican outlays each year totaling a staggering $100 billion.

Remember, we’re talking about just the investment accounts here, not the whole defense budget, so a spread of $100 billion in potential outcomes each year is huge.

If we look at the various pronouncements that Senator Obama made on the campaign trail about national security, it’s easy to find evidence that the Merrill Lynch theory of what drives weapons spending will be confirmed over the next few years…

— First, candidate Obama made getting out of Iraq his top defense priority.

— Second, he said he wants to put “people first” in his military spending plans.

— Third, he said he intends to review weapons plans to eliminate unneeded programs.

— Fourth, he said the military posture needs to be reoriented to deal with new threats.

— Fifth, he said he wants to “tilt the balance” in shipbuilding toward smaller vessels.

— Sixth, he said that missile-defense systems were needed but had not been adequately tested.

— Seventh, he said he wants to “dramatically reduce” the size of the nation’s nuclear arsenal.

— Eighth, he said he wants to reform the acquisition process and strengthen oversight of contractors.

Mr. Obama had positive things to say about a handful of weapons programs such as the Littoral Combat Ship and the C-17 cargo plane, but he was noticeably silent on many other efforts such as the Joint Strike Fighter and the Zumwalt-class destroyer.

When we combine his generally critical comments about current Pentagon acquisition programs and processes with the traditional Democratic affinity for burden-sharing with allies, non-military instruments of foreign policy and domestic entitlement programs, the new administration looks poised to prove that Merrill Lynch was right about the Democrats.

The President-elect’s recently announced domestic stimulus program contained no mention of how military spending might contribute to economic activity, and he remains committed to costly domestic initiatives such as universal healthcare coverage and energy independence that look unaffordable within current fiscal constraints.

So unless some major military threat arises to alter the new administration’s assessment of priorities, it seems nearly inevitable that the Pentagon budget will become a bill-payer for other items.

It is possible that readiness or personnel plans might be hit harder than investment programs in any such savings campaign, but the experience of the Carter and Clinton downturns suggests that weapons programs will be cut first and cut deepest.

Although budget analysts treat all defense spending as discretionary — unlike the formula-driven “mandatory” costs of entitlement programs — the reality is that some types of military outlays are much easier to cut than others.

For example, if you cut military pay and benefits the consequences are felt very fast in the field and on Capitol Hill.

If you cut the DDG-1000, or the Future Combat System, the impact is barely felt at all outside a handful of congressional districts and companies.

So both for circumstantial and ideological reasons the Obama Administration will move to cut defense spending, and it will probably look first to weapons programs as the big military bill-payer.

Thus, the current political landscape offers little refuge for defense contractors once policymakers conclude that threats have stabilized or are receding.

The Economic Downturn Undermines Defense Plans

Let’s turn now from politics to economics, the other factor that I identified at the outset as a key driver of defense industry fortunes.

Like many other analysts, I have been saying for years that defense spending is the only big component of national output not driven mainly by economic forces.

The conventional wisdom has been that defense spending is shaped by the other two factors I already discussed — threats and politics — with economics playing a less important role.

In fact, a major argument for owning defense equities over the years has been that they were “counter-cyclical” — meaning that they were not exposed to the commercial business cycle and therefore could be used as insurance in stock portfolios against economic downturns.

However, that line of reasoning has been undercut by three realities…

— First, some of the biggest defense companies, such as Boeing and General Dynamics, maintain product lines that are directly exposed to commercial markets.

— Second, all of the defense majors have pension funds heavily invested in equity markets that must be replenished when those markets take a tumble.

— Finally, most of us analysts who downplayed the exposure of defense spending to economic trends unconsciously assumed that America would remain the dominant global economy for the foreseeable future, and that may now be changing.

It is the latter development that I would like to focus on today, because the evidence is beginning to accumulate that America’s economy, particularly its industrial core, is in a long-term decline.

Common sense tells us that a poor country cannot be a military superpower, however few analysts have ever applied such thinking to the United States because it was taken for granted that America would be the biggest, richest economy in the world.

But nothing lasts forever, and the demise of America’s global economic hegemony may now be upon us.

Let me offer you some striking indicators…

— According the Central Intelligence Agency, incomes of the lowest 80% of U.S. households have not improved at all in 30 years.

— During that same period, the national debt has increased 1000 percent and America has gone from being the biggest creditor nation in the world to the biggest debtor nation.

— In the current decade, America’s share of global output has shrunken from 31 percent to 27 percent, while most job growth has occurred in government or areas like healthcare and education heavily supported by government.

— Meanwhile, U.S. manufacturing jobs have disappeared at a rate of over 40,000 per month for eight straight years, and the U.S. merchandise trade deficit has doubled to a staggering $800 billion annually.

— According to one estimate, manufacturing has shrunk from over 20 percent of the economy in 1980 to 12 percent today, resulting in the gradual loss of many industries such as commercial shipbuilding, consumer electronics, textiles, steelmaking and now automobiles.

The prevailing way of interpreting these trends is to argue that America is becoming a service economy, but recent history offers no example of a nation that was a major power while lacking a substantial industrial sector.

As any economic textbook will tell you, it is nearly impossible to preserve the value of a nation’s currency while running chronic budget and trade deficits of three to five percent of GDP, so the dollar’s days as a preferred global currency may be numbered.

The evidence does not indicate that America’s economy is in a brief downturn during which it will adjust before resuming dynamic growth.

Rather, the indications are that the economy is gradually declining relative to other nations, especially China.

That finding was highlighted in a recent CIA briefing to the new president, which strongly hinted that America’s capacity to continue its superpower status would be increasingly called into question in the years ahead.

I am not going to claim the ability to see the future, but it seems pretty obvious that current economic trends are going to have some negative impact on the nation’s propensity to sustain its current military posture.

When the government is spending money equivalent to 25 percent of national output and generating tax receipts equal to 17 percent of output — the Congressional Budget Office’s projection for 2009 — something has to give.

With military threats relatively muted and Democrats in control of the government, the negative trends in the economy will probably exacerbate the forces driving down military spending.

Now, the argument can be made that cutting weapons outlays when the economy is already skirting a depression doesn’t make much sense, and many of the workers in defense plants are card-carrying members of organized labor who tend to vote for Democrats.

But there are faster ways to stimulate a flagging economy than buying weapons, and as I already pointed out the Obama stimulus plan contains no mention of how military outlays can contribute to economic recovery.

So on present evidence, one would have to conclude that the nation is gradually losing the wherewithal to sustain its global military presence, and economic trends will tend to amplify the geopolitical and electoral developments already undercutting military outlays.

The bottom line is that the defense industry is facing tough times.

Which brings me to the question of how you should prepare to cope with such times.

Defense Companies Have Many Ways of Adapting

The biggest problem the defense sector always faces when demand flags is that it basically only has one customer, and the kind of behavior that customer rewards is so different from what gets rewarded in commercial markets that investors doubt the ability of defense companies to diversify.

Nonetheless, defense companies have a wide range of options for coping with hard times.

Let’s look at some business strategies they could pursue, going from the most modest to the most radical.

The first thing companies can do in a down market is simply lower expectations while outperforming other potential investments.

Investors will punish you on the day you adjust your estimates downward, but with the commercial economy skirting depression and treasury bills yielding a negative interest rate after inflation, it won’t be hard for defense contractors to outperform other investments.

Once the investor community grasps what its real choices are, sticking with slower-growing defense companies will probably still look like a good move.

A second time-honored strategy is to mine your multi-billion-dollar backlog by improving returns and seeking to extend existing franchises.

Defense companies sometimes tolerate sub-par returns in current business because they are trying to position themselves for new opportunities, but once the new opportunities dry up there’s little reason to retain unnecessary overhead or avoid squeezing the customer for higher profits.

So even as the growth in your revenues slows or reverses, it is still possible to increase returns for years to come through tighter management of backlog execution.

A third strategy that all of the companies in the sector will pursue is to improve business skills in order to steal market share from competitors.

Raytheon tries to do that constantly, and most observers will tell you that it has significantly improved its competitive standing vis-a-vis major competitors over the past several years.

However, it still commands less than ten percent of the domestic defense market, so there is plenty of room to grow revenues and returns if you can win more market share.

That can be achieved not only through internal improvements to marketing and execution capabilities, but also by hiring away talent from other companies, and undercutting their franchises with proposals that offer equivalent functionality at lesser cost.

A fourth, somewhat riskier, strategy is to broaden your business focus into adjacent federal markets.

As long as you are using the same skills and addressing a federal customer, investors will not view that as diversification even though the product doesn’t look like a military system.

Many of your skills are fungible across a wider range of federal customers than the company currently serves, so with the new administration focused on domestic initiatives it is sensible to put more effort into developing federal opportunities on the civil side.

All of your competitors are pursuing new business-development initiatives with the federal government in areas such as information services, healthcare and logistics, with the goal of broadening their business mixes in the federal market space.

A fifth strategy is to use the cash currently being generated by mature operations to buy other defense companies that fill gaps is existing lines, bolster forward revenues, or give the company access to new government opportunities.

There are any number of companies such as SAIC or ManTech that would strengthen your position in core markets, and the multiples being demanded by the sellers of such companies may weaken in the years ahead to the point where they look like real bargains.

Going one step further, a sixth strategy might be to seek a merger of equals with companies such as General Dynamics or BAE Systems.

Despite the small number of defense majors remaining in the business, there is relatively little overlap between Raytheon and several of its biggest competitors, and it might make sense to sell off some existing lines in order to achieve the mass needed to weather a prolonged downturn.

Mergers of equals inevitably raise issues about corporate culture and identity, but the most successful company in the sector, Lockheed Martin, came together as such a combination and seems to be doing very well.

A seventh, and distinctly more daring, option would be to diversify out of the federal sector.

Conventional wisdom on Wall Street says that defense companies lack the skills to compete in commercial markets, but GD’s success with Gulfstream and Boeing’s success with commercial transports says otherwise.

Raytheon has been in commercial markets before, so the possibility of returning there if defense demand becomes chronically depressed should not be discounted.

It might make more sense than pouring your hard-earned resources into a defense sector that shows scant potential for generating increased earnings during most of the coming decade.

But that raises the philosophical issue of why enterprises exist in the first place, which brings me to the final option — simply getting out.

You could argue that the coming downturn in defense is just a return to conditions that prevailed at the beginning of the decade, when the sector was facing a second consecutive decade of depressed demand.

There still is no peer competitor on the world stage to rival America, and the global war on terror has wasted a lot of money pursuing a very modest threat, so maybe the smartest thing to do is monetize your assets before competitors catch on that there isn’t going to be much of a defense business for sometime to come.

That strategy doesn’t compute with most people in the defense industry, but I watched General Dynamics sell itself off in the early 1990s, and it was considered a very successful strategy by investors at the time.

I’m not arguing your company should do that now, but as I said earlier — nothing last forever, and the main goal of publicly traded companies is to get the best returns for their shareholders.

At least that’s the way it looks to me — so now tell me, how does it look to you?