Why Defense Demand Will Weaken — And How Military Contractors Can Cope

Remarks to the Price Waterhouse Coopers Executive Roundtable

Price Waterhouse Coopers has asked me to speak for the next hour about the defense outlook, which I have interpreted to mean the business outlook for U.S. military contractors over the next few years.

I am sorry to say that it is not a pretty picture, and defense companies may need to make major changes in their strategies to sustain the strong financial results of recent years.

Since it is already mid-afternoon, I do not propose to spend a full hour depressing you about how difficult business conditions might become in the defense sector.

Instead, I will devote the first half of the hour to discussing why some downturn in defense demand is nearly inevitable, and then spend the second half responding to your questions and comments about my remarks.

Toward the end of my prepared remarks I will offer some ideas about how defense companies can cope with the coming downturn, but like the four stages of grief, the indispensable first step is to recognize that the world really is changing in ways you are not going to like.

The last ten years have been kinder to the defense industry than just about any other sector of our economy.

Military spending has risen from 300 billion dollars the year President George W. Bush took office to 700 billion today.

That means America — five percent of the world’s population — now accounts for nearly 50 percent of all global military spending.

However, during the same ten years, America’s share of global economic output plummeted from nearly a third to less than a quarter.

In other words, our portion of the global economy has fallen by about one percentage point each year for ten straight years.

The growing gap between our military power and our economic power has become unsustainable unless there is a basic restructuring of federal spending priorities.

Since no such restructuring has been proposed by either major political party, I conclude that defense spending must fall considerably in the near future.

For the purposes of today’s meeting, though, it isn’t enough to predict that the defense “top-line” will fall, because your companies depend for their revenues on particular categories of spending within that top-line.

Therefore, we need to know not only what the trend will be in overall defense spending, but how the composition of military spending may shift in the years ahead.

I’m going to explore both of those topics by spending a few minutes looking at each of the three big factors driving demand for military goods and services — threats, politics and the economy.

Specifically, I will look at how the nature of the threats we face, the priorities of our political leaders, and the performance of our economy is likely to shape the size and composition of military outlays through 2015.

Once I have laid out the case for a fairly severe downturn in demand, I will identify some strategies for dealing with the resulting business environment.

So let’s turn now to the first big demand driver, the factor most experts say determines our military requirements — threats.

Threats

Threats to our security are the main reason we have a military.

However, if you trace U.S. military spending back to the early days of the Republic, an interesting pattern emerges.

Between 1800 and 1950, the United States typically devoted about one-percent of its economy to military activities.

But every 30 years or so, military spending would spike in response to a threat such as southern insurrection or fascism.

What’s striking about that pattern isn’t the spikes, but the consistency with which military spending always reverted back to one-percent of the economy once the danger had passed.

That tells you that most of the time, the political system did not feel threatened by external enemies — which is why there was barely any defense industry in America beyond a handful of government-owned shipyards and depots.

When threats appeared, the economy would be mobilized for war production, but as soon as they waned it would demobilize and return to its previous commercial pursuits.

However, that pattern shifted decisively at about the time that I was born, 1951, because a different kind of threat materialized that looked unlikely to go away anytime soon.

The new threat was communism, specifically the global challenge posed by an ascendant Soviet Union, and it persisted for four decades during a period we came to call the Cold War.

It was the danger posed by communism that made the modern defense industry possible, due to four specific features…

— First, the threat was widely recognized and urgent; we knew our survival was at stake, and so we poured resources into mounting an adequate defense.

— Second, the threat was much more durable than previous dangers; it continued at a high level of intensity for 40 years.

— Third, the threat was focused; we knew who the enemy was and precisely what he was doing that endangered us.

— Fourth, the threat was industrial and technological; it arose mainly from the mass production of continuously improved aircraft, missiles, tanks and warships.

In response to this persistent, undeniable danger, America spent ten percent of its economy on defense in the 1950s, nine percent in the 1960s, and six percent in the 1970s and 1980s.

The buying power of the military budget was remarkably stable during this period because the economy was growing steadily as the percentage of it devoted to defense gradually declined.

So we became accustomed to the idea that having a big, dedicated defense industry was just the normal state of affairs in the modern world.

In fact, the communist threat persisted for so long that by the time it disappeared in the early 1990s, many people working in the defense sector had forgotten that was why the industry came into being in the first place.

But they soon were reacquainted with the reality that threats drive demand in the defense business.

When Dick Cheney became defense secretary the same year the Berlin Wall came down, he was determined to stop spending money on weapons systems no longer needed to deter the Soviets.

During his four-year tenure at the Pentagon, Cheney canceled a hundred major weapons programs — everything from the Abrams tank to the Seawolf submarine to the B-2 bomber — because he believed that threat conditions no longer justified continued investment in those systems.

Eight years after Cheney left the Pentagon, as the American Century was ending…

— Defense spending had drifted below three percent of the economy.

— The number of major military contractors had shrunk by two-thirds.

— And Republican presidential candidate George W. Bush was calling for the Pentagon to “skip a generation” of weapons.

While the rest of the economy basked in the warm glow of the dot.com boom, the defense industry had fallen to its lowest ebb in half a century, with scant prospect of recovery.

What saved military contractors was a new threat — the terrorist attacks of 9-11 that led to a global war on terror, and then later to a protracted military campaign in Iraq.

The new threat not only created a surge in demand for military goods and services, but also made it easier for defense secretary Donald Rumsfeld to fund ambitious investment plans in pursuit of “military transformation.”

Thus, a decade that began with defense companies in despair about future business prospects ended with military outlays at their highest level since World War Two.

Just as the threat posed by communism had given birth to the modern defense industry during the early days of the Cold War, so a different kind of threat at the dawn of the new millennium gave that industry a renewed lease on life.

By the time Congress and the public began questioning whether the new danger really was as serious as initially feared, the nation was engaged in two different wars that would require years of heavy spending before U.S. troops could be extricated.

That brings us to where the industry stands today — flush with cash after a decade of continuous increases in defense spending.

Today, the industry once again is confronted with the likelihood that receding threats will cause a decline in demand for its products.

The doubts about future demand don’t arise just from the fact that America’s role in Iraq is winding down, but also from a gradual weakening of official concern about the severity of future threats, and the magnitude of military preparations that might be required to address them.

If you peruse the description of threats in this year’s Quadrennial Defense Review, you will see what I mean…

— It warns that we face a “complex and uncertain security landscape” in which the distribution of economic and military power is shifting.

— It says that globalization has transformed the process of technological innovation while “lowering entry barriers for a wider range of actors to acquire advanced technology.”

— It identifies competition for resources, urbanization, climate change, new diseases and demographic trends as sources of concern for the future.

But what it doesn’t say is that our way of life is in imminent danger, or that we must sustain a global crusade against enemies who would seek to destroy us.

The urgent sense of danger that characterized official threat assessments at the beginning of the Cold War and earlier in this decade has been replaced by a more abstract and detached description of security challenges.

The threat described in the QDR isn’t sufficiently focused or worrisome to sustain a coherent, robust defense posture over the long term.

The political system has assimilated the implicit message that we aren’t in as much danger as we used to think we were, and so it has begun dismantling the military modernization plan put in place by the previous administration.

Programs like the Future Combat System, the Next Generation Bomber and the CGX missile-defense cruiser have been canceled, and additional program kills are likely in the near future.

We seem to be witnessing the same pattern that always unfolds in American history when threats recede — weapons accounts decline first and decline furthest, with dire consequences for military contractors.

The obvious conclusion is that the defense sector is headed into a downward cycle of eroding revenues and returns, driven at least in part by the fact that today’s threats lack the power, the persistence, and the immediacy of past dangers.

Politics

That brings me to the second big demand driver for military goods, politics.

People in the defense industry usually try to steer clear of politics, but their main customer is a political system called the federal government.

Politicians are the ultimate arbiters of how much money military services and intelligence agencies get, and they often make such decisions on a line-by-line, program-by-program basis.

So it is important for defense contractors to understand the role that politics plays in driving military spending patterns, especially how the two major political parties approach weapons outlays.

And there we see a striking divergence, which has been illuminated in research conducted by Ronald Epstein — a longtime analyst at Bank of America MerrillLynch.

Based on detailed statistical analysis of federal spending over the last 50 years, Epstein finds that when the Republican Party controls the White House and/or the Senate weapons spending almost always goes up, whereas when Democrats are in control it almost always goes down.

I know that doesn’t come as a huge shock to you, but maybe this will: Epstein found the link between party control and weapons spending was so strong that it explained 90 percent of all the changes in weapons spending over the past 50 years.

In other words, party control matters ten times more than threats, public opinion, and everything else combined when it comes to predicting whether weapons outlays are headed up or down.

Epstein could not find a clear statistical link between weapons spending and who controlled the House of Representatives, but when it came to the White House and the Senate, the impact of partisan politics was overwhelming.

This seems to be a relatively recent development in American history since Democrats presided over four of the five big military buildups in the Twentieth Century, but it appears that they turned against weapons spending during the Vietnam War, and stayed that way right up to the present decade.

We can see evidence of Democratic aversion to weapons outlays in the program cuts defense secretary Robert Gates proposed four months after President Obama took office — cuts that Gates now says reduced future weapons expenditures by 330 billion dollars.

Beyond the early weapons cuts, there are several features of the Obama agenda that sound distinctly unfavorable to the fortunes of defense contractors…

— First, the President has an ambitious array of domestic program initiatives that will be tough to fund in the current fiscal environment.

— Second, Obama remains committed to not raising taxes on the middle class, which is one reason why budget deficits look likely to remain sky-high throughout his time as chief executive.

— Third, he is surrounded by left-wing academics who prefer “smart power” and diplomacy over the muscular unilateralism of the Bush years.

— And fourth, Obama counts public-sector unions as part of his electoral base, which makes him favorably disposed to efforts that would “insource” services previously contracted out to the private sector.

Put those priorities together with the party-driven spending patterns described in the Epstein model, and it’s easy to see why weapons spending might plummet in the years ahead even if threats weren’t receding.

Epstein has predicted that the Obama Administration might spend as much as a hundred billion dollars less on weapons each year than a McCain Administration would have.

That’s not a hundred billion dollars off the defense top-line, it’s a hundred billion dollars less in just the investment accounts, every single year.

Clearly, politics can have a decisive impact on defense industry profits.

Economy

We come now to the third and last big driver of demand for defense goods — the economy.

Some defense experts would tell you the third big demand driver is strategy, but strategy usually is a response to threats, politics and the availability of money.

In other words, strategy is not an independent variable — it depends on more basic factors.

The availability of money, on the other hand, is arguably the most fundamental factor determining levels of demand for defense goods, because if the government lacks the economic resources to sustain its defense posture that trumps even threats and politics in deciding outcomes.

So the possibility that our economy is in decline, and that tax revenues might be too low to cover federal obligations in the future, is potentially a very serious development for defense contractors.

I mentioned at the outset of my remarks that the U.S. economy has fallen from about 32 percent of global output ten years ago to 24 percent today, and now I’d like to elaborate a bit on that theme.

Shortly after being elected, President Obama received a briefing from the National Intelligence Council on America’s standing in the world, the latest in a series of such assessments that the intelligence community puts together every five years.

The section of the briefing on economic trends said…

In terms of size, speed, and directional flow, the global shift in relative economic power now under way — roughly from West to East — is without precedent in modern history.

The intelligence community had never before made such a statement in one of its five-year assessments, and the fact that it did in 2008 sent a sobering message: America’s economy is gradually losing the vitality that made our nation a superpower.

Said differently, the economic challenges we face aren’t just a temporary rough patch resulting from a downturn in the business cycle.

There is an underlying, secular decline that has been under way for some time, and it is slowly robbing America of the economic preeminence it enjoyed throughout the second half of the Twentieth Century.

Let me give you some indicators tracking that decline…

— Employment in the United States grew 20 percent in the 1980s and 20 percent in the 1990s, but it has only grown one percent since the beginning of the new millennium.

— The United States has lost an average of 40,000 manufacturing jobs every month for the last ten years, and accumulated the biggest merchandise trade deficit in the history of the world.

— According to the CIA’s World Factbook, median household income in America has not increased at all in the last 30 years, and over the past ten years household net worth has fallen 13 percent.

There are many other such indicators, but they all point to the same conclusion: the U.S. economy is not performing anywhere near as well as it did in the previous five decades that we call the “postwar era.”

One consequence of our waning economic strength is that the federal government cannot generate sufficient tax receipts to cover the cost of its activities, so it is borrowing money at a furious pace.

I pointed out to the senior management of DRS Technologies at a March offsite that on the day I was giving the speech to them, the federal government would need to borrow as much money as DRS had booked in sales the entire previous year.

Do the math: if the federal government’s projected deficit for fiscal 2010 is 1.34 trillion dollars, that works out to about 3.7 billion dollars in new borrowing every day.

Add in the additional borrowing required to turn over existing debt, and Washington is borrowing the equivalent of one DRS Technologies every day.

Such trends moved Harvard economist Larry Summers to pose a pointed question shortly before he joined the Obama Administration…

How long can the world’s biggest borrower remain the world’s biggest power?

Well, we’re going to discover the answer to that question over the next ten years because the Congressional Budget Office projects that the government will add an average of a trillion dollars to the national debt every year during that period.

The government has a bi-partisan debt commission looking at how to get annual deficits down to no more than the cost of interest on the debt, but CBO says by 2020 interest payments on the debt could be nearly a trillion dollars each year.

I don’t know whether the federal government’s borrowing binge will end in some grand political compromise or in an economic catastrophe, but it will end.

When the inevitable downward adjustment in federal spending arrives, defense will have to take its share of cuts — and maybe a disproportionate share if threats are low and the appetite for entitlements remains high.

A top-line cut of military outlays calibrated to the size of the deficit and the military share of federal spending would result in decreasing Pentagon expenditures by over 200 billion dollars annually.

But of course it won’t be that simple — big budget cuts will only come at the conclusion of an angry, divisive political debate that tests the resilience of the democratic process.

Whichever path we choose, fiscal responsibility or procrastination, it is likely to be quite traumatic in the end.

We either will drastically curtail the availability of federal funds to a vast array of programs, or we will wake up one morning to discover the world no longer wants any more of our I.O.U.s.

The bottom line for military contractors is all too clear: our economic and fiscal circumstances dictate that we cut defense spending in a big way, and that is what we will soon do.

Responses

Well — have I worried you enough yet?

I could go on.

So far, all I have discussed is the big demand drivers external to the Pentagon that are pressuring policymakers.

There is a separate set of demand drivers within the defense department, and they too are working mostly against military contractors at the moment…

— Secretary Gates is “rebalancing” investment priorities away from conventional warfare, to put more emphasis on people skills associated with irregular warfare.

— The cost of military pay and benefits continues to increase faster than inflation or overall defense spending, reducing the availability of funds for weapons.

— Administrative and technical services previously out-sourced to the private sector are being pulled back in-house pursuant to new contracting policies.

These internal drivers are combining with the external factors I already discussed to profoundly alter the composition of spending within the defense department budget.

Simply stated, our military posture is becoming more labor-intensive as money migrates out of technology and into people accounts.

Thus, the likely downward drift of defense spending in future years may be made worse for military contractors by a disproportionate decline in expenditures for conventional weapons and contracted services.

The question is, what should you do about it?

That brings me, finally, to the subject of corporate responses — in other words, how your companies can cope with the coming downturn.

There are several time-honored tactical responses to downturns that some sector players have already embraced, and you can too…

— First, you can lower investor expectations in the hope that shareholders will adjust to changing business conditions without bailing out of your stock.

— Second, you can change your publicly-reported financial metrics to favor measures that highlight the positive, for example by substituting return on invested capital for return on sales.

— Third, you can “mine” your backlog to secure better margins on existing work, or extend that work well beyond currently booked orders.

— Fourth, you can cut discretionary expenses like marketing and research in recognition of their diminished returns during a period of market contraction.

— Fifth, you can bolster your revenue line by making acquisitions that compliment existing franchises, acquisitions that might well prove accretive from day one as valuations fall in response to softening demand.

We know from past experience that these kinds of tactical moves can work wonders, because companies coming out of periods of robust market growth often have a lot of fat that can be trimmed to sustain profits into weak periods.

But the problem with tactical responses is that they don’t really change your circumstances, they just make the best of a bad situation.

If the downturn lasts for a long time then eventually you will have to do something strategic to prevent investors from drifting away.

My favorite example of a defense company that did something strategic when demand collapsed — in fact, that completely transformed itself — is General Dynamics.

In 1990 the nation’s number-two military contractor found itself facing the end of the Cold War midway through some very expensive investments in future weapons that defense secretary Dick Cheney decided to cancel.

Programs like the Seawolf submarine, and the A-12 attack plane.

The Crown family that controlled a quarter of GD’s stock decided the company needed a fundamental shift in direction, and brought in a new CEO named Bill Anders with instructions to “monetize” the business — in other words, sell it off.

The resulting “fire sale” generated handsome returns for a few years, but left GD a mere shadow of its former self.

All of its aerospace businesses — aircraft, missiles, rockets — were gone, and the only things left were the properties that had proven hardest to sell: tanks and submarines.

After operating the residual enterprise for a few years as leanly as possible, it dawned on management that the defense sector was full of properties nobody seemed to be interested in even though they were generating a great deal of cash — properties that might be acquired in accretive transactions, and then run quite profitably.

Over time, that initial insight evolved into a numbers-driven, somewhat contrarian approach to the defense business that consistently delivered superior results to investors.

For instance, GD bought business-jet maker Gulfstream even though Wall Street was warning defense companies not to diversify into commercial lines.

It bought armored-vehicle and naval-shipbuilding businesses at a time when nobody else wanted them, and the defense units of commercial telecom companies that thought dot.com opportunities were the only business worth pursuing.

These moves paid off very well for GD, because its leaders were able to look beyond the conventional wisdom and see how unpopular businesses could be made to generate good results even in a depressed market.

General Dynamics stuck to its strategy and its metrics while the rest of the defense sector chased the dot.com boom, then military transformation, then the global war on terror.

And as a result, they became the favorite defense holding of many sector investors, not to mention a preferred supplier to their military customers.

There are at least three lessons to be learned from GD’s success…

— First, it is possible to do well in the defense business even during down times.

— Second, success begins with having stable measures of merit that can be precisely tracked.

— And third, you probably aren’t going to stand out by doing what everybody else is doing.

That last point is crucial, because GD has thrived in large part by following the numbers and ignoring fashion.

Its approach has worked so well that one by one all of its industry peers have adopted similar strategies, but when GD first began implementing its numbers-driven approach, it looked distinctly out of place in the defense sector.

GD consciously sought to be different, and it worked.

So given all that, what unfashionable, contrarian ideas might your own companies consider to weather the coming storm?

I’d like to mention three.

First of all, don’t get bigger — get smaller.

Since the Cold War ended, the defense industry has been through a decade of major consolidation, followed by a decade of rapid growth in new business areas like networking and logistics.

One consequence of being on that roller coaster is that even the best-run companies in the sector have accumulated business lines that aren’t a good fit for either their operating cultures or the future business climate.

There’s something to be said for mass and diversity when facing uncertain times, but why hang on to businesses that aren’t likely to perform well in the future?

The presence of such operations in your business mix drags down overall results and forces management to take compensatory steps like making acquisitions that may have nothing to do with remaining competitive in core competencies.

So why not get rid of the bad fits and under-performers before valuations deteriorate, and show Wall Street how well you can perform in the areas where you know you’re an industry leader?

There’s a hint of that reasoning in Northrop Grumman’s recent adjustment of its performance metrics to stress the efficiency with which capital is deployed over mere revenue growth — a shift that may have implications for whether it remains in naval shipbuilding.

A second idea worth considering is diversification — not just away from the Pentagon customer, but away from federal markets in general.

As you know, many companies in the defense sector are trying to grow their business with the federal government’s civil agencies.

However, those agencies are subject to many of the same fiscal stresses pressing down on the defense department.

General Dynamics has demonstrated with its acquisition of Gulfstream that it is possible for defense companies to operate successfully in commercial markets without undercutting their military competencies.

United Technologies and Textron also manage to do well in both military and commercial markets, perhaps because like GD they give business units the autonomy needed to respond to each market on its own terms.

It might be useful for companies that are now focused solely on the federal marketplace to study how Gulfstream thrives within GD, or how Sikorsky does so well within UTX.

Wall Street analysts don’t like to see defense companies diversify because it makes stocks harder to analyze, but if they can live with Lockheed being in everything from satellites to warships to information services, then surely they can accept some defense-sector diversification as a hedge against declining Pentagon demand.

A third and final idea is for U.S. military contractors to get much bigger in international markets.

Many defense companies have been so busy chasing domestic opportunities over the past ten years that they have not given much thought to how they might sell into foreign markets.

As a result, only one of the big defense contractors generates over 20 percent of its military sales from foreign sources, even though most global spending on military hardware and services occurs outside the United States.

With the prospects for the U.S. economy looking considerably less positive than in places like East Asia, it’s just common sense that companies should put more effort into selling military products overseas.

After all, America still makes the best weapons in the world, and the Obama Administration is rewriting trade regulations in the hope of doubling U.S. exports over the next five years.

So there you have three simple ideas — downsizing, diversifying and globalizing — that collectively could make it much easier for your companies to cope with the coming downturn.

I understand the resistance to changing business formulas that have worked well in the past, but U.S. demand for military goods and services is probably headed downward for some time to come, so I wouldn’t recommend trying to just wait out the impending defense recession.