In the future Defense economy, who lands the biggest piece?
Pressure is the impetus for change. Since the end of the Cold War, the pressure has been building for the Defense industry to fundamentally re-imagine itself to reflect the realities of a changing world. The threat is different today than it was 20+ years ago. But after two wars and a score of contingency engagements around the globe, the Defense industry is all too ready to forget the lessons of recent conflicts and return to the happy predictability of a Cold War adversary.
Now the national budget crisis has introduced a different kind of pressure. Increasingly, the U.S. no longer has the resources to simultaneously equip for the wars we would prefer to fight and support the exigencies of the messy little wars we are fighting. Hard choices have to be made, and I predict that the Defense industry that emerges from this period of change will be fundamentally different from the one that we know today.
As a nation, we cannot afford to pay for a standing Defense industry as a strategic hedge against remote contingencies. More than ever, we need a Defense industrial base that is an extension of the commercial marketplace. One where costs, resources, and innovations can be shared rather than solely underwritten by the American taxpayer. Over the next 10-15 years, these dynamics will combine to produce a Defense industry that both consolidates and diversifies.
Expect investments in Major Defense Acquisition Programs (MDAP) to continue to fall for the foreseeable future in favor of smaller scale innovation programs that target emerging military needs. Decreasing MDAP investments erode the competitive advantages (e.g. size/scale, industrial base, processes, etc.) of the Tier 1 system integrators and enable mid and small size firms to more effectively compete for Defense dollars. Moreover, the migration of Defense spending from MDAP’s to small contract engineering and services-type contracts has incentivized many large defense businesses to move down market into more commoditized industry segments, where competition on price is fierce. For the Tier 1 systems integrators, the move down-market over the past decade has been accompanied by a divestiture of strategic infrastructure assets in order to create more competitive rate structures. One highly visible example of this trend is Northrop Grumman’s sale of Huntington Ingalls.
For good or ill, heavy infrastructure creates an implicit strategic focus (or center of gravity) for a company, and the loss of such infrastructure often leaves a gaping void. Combined with the competitive pressures to diversify and capitalize on smaller-scale opportunities, the Tier 1 companies of the future will increasingly resemble holding companies like L-3 Communications and to a lesser extent SAIC than tightly integrated Defense juggernauts like Lockheed Martin. To the extent that big infrastructure Defense survives the next two decades, it will emerge more lean, focused, efficient, and much, much smaller.
I want to circle back around to the issue of cost before wrapping up. The shrinking Defense dollar relative to the explosive diversity of future needs is the trend that will shape the emerging Defense economy. Historically, Defense contracts have been awarded based on two criteria: “lowest cost” (meaning lowest cost) and “best value” (meaning cost doesn’t really matter). In the Defense marketplace of tomorrow, “best value” takes on a new meaning: the bestest for the cheapest. Generally speaking, the engines of innovation in all industries are the small and mid-tier companies. In Defense, the role of the the Tier 1 systems integrators has largely become one of packaging up these innovations for sale to the government. Looking ahead, is the government going to continue to be willing to pay a premium to the market leaders for what amounts to flow-through innovation? I am guessing no.
I predict that all of the aforementioned factors will combine to produce a non-cyclical reduction of large Defense contractor market share by 30-40% over the next two decades, making room for substantial new mid-tier companies to emerge. I am working on a model that, if successful, will identify the companies who will capitalize on this trend. More on this topic in subsequent posts…