U.S. Defense Industry Could Change In Blink Of An Eye

The legacy defense-industrial base is seeking a truce with U.S. government acquisition reformists just in time as long-term growth projections begin to stall. But instead of trying to stuff the proverbial genie back into the bottle, contractors should prepare for even more change.

Going into the latest financial reporting season, defense stakeholders had been riding a near-two-year high due to the industry’s resiliency during the COVID-19 pandemic, as well as a boost from a pleasantly surprising Biden administration budget request that maintained Trump-era spending levels. But third-quarter financial results turned into a rout, not because of red ink as much as the dawning realization that stalwart defense primes and major suppliers face flat defense budgets and an existential reshaping of the sector.

“This quarter was one of the most dramatic we have ever experienced in defense, rocking its credentials as a ‘defensive’ sector,” analysts Rob Stallard and Karl Oehlschlaeger of Vertical Research Partners write in a Nov. 17 report. They expect publicly traded defense companies will be “in the doghouse for a few months” more.

Some of that is because defense finds itself in a historic transition. The Afghanistan withdrawal and recent Russian and Chinese anti-satellite and hypersonic space tests punctuate the fact that U.S. national security undeniably has returned to a peer-level paradigm, an environment last experienced in the early 1990s against the erstwhile Soviet Union.

At recent Aviation Week Defense Chain, Program Excellence and Mergers and Acquisitions conferences—which were under Chatham House rules, so no attribution is allowed—a key takeaway for industry leaders was how the defense sector is facing a decade of disruption as it resets and, in some cases, tries to catch up to peer adversaries after three decades of counterinsurgency wars, industry consolidation and the commercial sector provision of advanced technologies.

Every transition is hard, but this one will be harder because the defense industry still is focused largely on providing metal-bending capabilities to meet 20th-century military requirements. Yes, the wars in Iraq and Afghanistan required new weapons such as armed drones and tactical intelligence, surveillance and reconnaissance systems, but those are far more similar to what the defense-industrial base has provided. And like airlines, primes and top-tier aerospace suppliers only became hugely profitable at providing these weapons in the past decade or so.

But now the government is hungry for change and spending on 21st-century capabilities such as artificial intelligence and machine learning, cloud and edge computing, big data analytics and others. One industry analyst foresees roughly $121 billion worth of reallocated U.S. defense research, development and procurement spending through fiscal 2026 alone.

Think about a national defense strategy built around the Joint All-Domain Command and Control (JADC2) concept and not the Lockheed Martin F-35 or General Dynamics (GD) Abrams main battle tank. Asked to look five years ahead, an industry veteran quipped: “We won’t be talking about platforms, we’ll be talking about the network.”

Longtime executives tell Aviation Week they have never known government customers to be so open to new ideas. What is more, the mind shift is spreading in Washington. A whole new armed service, the U.S. Space Force, has been created with marching orders to look well beyond the legacy aerospace industry and to use commercial acquisition practices as a starting point.

“The divergence is driven by a Defense Department emphasis on advanced technologies and not force structure,” Bernstein analyst Doug Harned and his team affirm in a separate October report. “The approach appears to now have more congressional support.”

The legacy defense industry is not necessarily doomed. “All contractors likely have exposure, as the network is more than just a network or product, but a multidomain intelligence vehicle tying in all Defense Department assets from sensor to shooter,” note Jefferies analysts Sheila Kahyaoglu and Greg Konrad in their own report.

But change is hard; just ask Lockheed Martin or General Dynamics. Lockheed’s stock price is lower than where it started this year, in part because Chairman and CEO Jim Taiclet has been spotlighting the need for  the company and the legacy industry to adapt to what defense officials have been saying for years. Lockheed has trademarked its campaign “5G.mil.” While good for branding, the campaign also invites second-guessing by shareholders who do not get it yet or just do not want to follow the transformation.

GD, meanwhile, saw credit-rating agency Moody’s Investors Service downgrade its debt rating in October, essentially blaming a lack of promised benefits from that company’s $9 billion acquisition of federal information technology (IT) specialist CSRA. The 2018 acquisition made sense, according to one thesis that still stands. Federal IT services companies can compete for some AI, networking, cloud migration and other work, along with systems integration, according to the Jefferies analysts. But as GD shows, just ingesting classic federal IT workers is no guarantee of financial success.

Part and parcel to the paradigm shift roiling the legacy defense industry is that it finally faces outside competition. Anduril, Palantir and other Silicon Valley-rooted companies are increasingly winning Pentagon contracts, and they come on top of SpaceX’s disruption of government launch and orbital services.

Amazon Web Services, Google, Microsoft and Oracle are competing again for a multibillion-dollar Pentagon-wide cloud contract. Palantir in October won a U.S. Army award worth up to $823 million to deploy its Gotham big-data analytics system in support of the armed service’s intelligence efforts. At Baird’s fourth annual Government and Defense Conference in November, an Anduril executive reiterated the company’s intent to become a top defense prime, and no one in the audience snickered. A Palantir executive noted how his company’s market capital of $43 billion rivals L3Harris Technologies, the self-titled sixth defense prime.

For an industry used to enjoying a wide moat, with high barriers of entry due to regulation and long-standing customer relationships thanks to revolving-door staffing, the new reality likely will be more jarring than any of the Washington-based acquisition reform efforts of recent decades. In the good old days, defense primes just worried about fixed-price development contracts or losing total control of the intellectual property behind weapon systems whose costs were paid for by the government.

Now, primes also must operate more akin to their tech competitors, even when they own the underlying platform or system. “What’s going to make it interesting for us as Lockheed Martin,” Taiclet acknowledged in October, “is we’re going to have to figure out how to translate an upgrade that we can do every six months into revenue for our company. The Silicon Valley companies are going to say: ‘Look, I’ve got a patent; I license that patent. You’ve got to pay me a subscription. That’s how I do business.’ And we’re going to have to figure how to translate that cost . . . to a DD Form 250 sale of an aircraft or an upgrade of a modernization program.”

Not surprisingly, the legacy industry is begging for relief. Northrop Grumman Chairman, CEO and President Kathy Warden, who eschews media interviews, in November sat for a friendly discussion with a Washington think tank. She lamented the government’s accounting compliance regimen and fixed-price development contracts drive, and she called for more certainty for primes that research programs will get turned into programs of record, which is the lucrative, long-term segment. Last but not least, she pointedly harkened to early Cold War decades when the government led research spending and the commercial sector followed.

“If we want to be able to develop capabilities that are truly innovative—meaning they are not available on the commercial marketplace—that give our military, intelligence and policymakers options that other nations don’t have, or even individuals operating at adversarial means, then we have to have something above commercial grade, and that’s what our government has funded in the past,” she said.

But those days are gone, in part because they led to Pentagon acquisition waste scandals in the 1980s-2000s. While Washingtonians still debate whether the $600 hammer was just an accounting artifact, many have bemoaned the military-industrial complex’s hold on acquisition efforts for generations, along with growing shareholder returns that outpaced program performance. For her part, Warden asserts that industry is more efficient and moral today and thus would not develop a $600 hammer now.

That is probably true, but larger affordability issues remain, such as the Pentagon being vendor-locked into a prime for decades, as well as a dearth of competition overall, or a lack of out-of-the-box thinking from contractors for which government customers have been desperate. Indeed, legacy industry will not hesitate to lobby for a franchise weapon product, even if it is not what defense policymakers say is needed, and to run to Congress stressing their jobs-creation importance in local districts, even as they employ fewer workers each year.

With new peer adversaries, new technology and nontraditional companies, the government has a chance for something new, and it is hard to see things going back. The atmosphere is pregnant with the potential for dynamic change in military acquisition, perhaps more so than since the dawn of the modern military-industrial complex. As it often happens, the transformation could continue slowly, methodically, until a tipping point is reached. But make no mistake: In the blink of an eye, a mere decade or less in the defense industry, the business of defense and the defense industry itself could look significantly different.