booz & company 2013 defense industry perspective

2013 Defense Industry Perspective

The 20-year experiment with a pure-play defense industry is likely coming to

an end. Once every two to four decades, the industry undergoes a major

transformation. The development of a formalized multisector industrial base

in World War II and the consolidation into dedicated defense integrators in

the 1990s are two examples. Today’s declining budgets and changing

customer requirements, and the increasing success of nontraditional

competitors such as Cisco, Eurocopter, and even Boeing Commercial

Airplanes signal that the industry’s status quo is likely untenable. Some

portions of the sector may become more stable by spanning defense and

commercial applications, while others may be more viable as arsenals or

national champions, where there is only one competitor per segment.

Given that such inflection points happen perhaps once or twice in a typical

career, management teams in place today have a particular challenge: to lead

their companies through an environment that few in their organizations have

experienced. Indeed, few leaders may have been in management positions

during the last industry inflection point.

With the cost structure of the industrial base unsustainable, and with

valuations nearing probable lows, 2013 will be an interesting year for both

organic and inorganic transformations. The recipe for success in this type of

environment can be distilled into a single imperative: manage the company as

a business rather than as a collection of programs.

We offer below a summary of our thoughts for success in the defense sector

over the coming year—specific challenges and specific prescriptions for how

best to address them.

Challenge 1: Steep Decline in Federal Spending

As we write this in late 2012, there has already been a huge decline in the U.S.

defense budget for Procurement and Research, Development, Test &

Evaluation—one-third lower than its peak. This drop-off over the past few

years has been mirrored in many other countries. Given the lag between

budgets and outlays, some companies may still feel insulated from the

decline. But tackling the fiscal situation—both in the U.S. and globally—will

require that defense spending be reduced further. Although we expect the

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decline to be less severe than in the last two downturns—when U.S.

acquisition funding declined roughly 50 percent from previous peaks—there

are more cuts to come.

This means that the primary mechanism for shareholder value creation by

most defense companies over the past decade—growth in an expanding

market—is no longer available. This new reality applies to both hardware-

centric and services-centric companies. Creating value will require alternative

methods, some of which will be understandably unfamiliar to current

management teams, given the length of time that has elapsed since the

industry as a whole invoked these methods.

The spending decline also means that capacity—a lot of capacity—has to

come out to keep programs even moderately affordable. In the last U.S.

downturn, from 1988 to 1995, capacity was reduced significantly across many

segments, including, for example, fixed-wing aircraft (approximately 20

percent of production square footage). This was how companies managed to

maintain their customers’ buying power as well as create shareholder value.

In fact, 30 large industrial companies exited the defense business during the

last downturn.

Challenge 2: Evolving Customer Requirements

We are more than 20 years past the end of the Cold War, yet many defense

company capabilities are still built around the extreme customer intimacy

and exquisite point-solution systems development that characterized the

Cold War era. Today, many threats are less predictable and tend to evolve

more rapidly. This shift has raised questions about whether the capabilities

systems of the typical defense company are obsolete. Defense companies

need faster development and fielding cycles to remain relevant for large

portions of their core markets.

Challenge 3: The Rise of New Competitors

Nontraditional companies—Accenture, Airbus, Apple, Cisco, Dell,

Eurocopter, and Pilatus, among others—have become increasingly successful

in the defense sector. Indeed, if you exclude Cold War–era systems, these

types of companies account for about 40 percent of U.S. acquisition spending

today for major hardware programs;; services spending is similarly split.

Traditional defense companies, which are sometimes slower to deliver and

more expensive, have had difficulties competing against these new

competitors, even in traditional “core” markets. These traditional companies

will need to determine whether they can compete in their core markets

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without development of commercial-like capabilities and, if not, how

commercial-like capabilities can coexist with traditional defense capabilities.

Challenge 4: Shareholder Suspicion Regarding Strategic Investment

Today, much of Wall Street is treating the defense sector like an industry in

irreversible decline, and recommending that defense companies forget about

growth and focus on maximizing dividends. This investor mind-set has been

reinforced by share buybacks and dividend yields that in some cases rival

those of utilities and tobacco companies—with the implicit message that there

is little rationale for internal strategic investment.

Some of the sector has painted itself into a corner by setting shareholder

expectations for continued high dividend yields, rather than making the case

for alternative methods of creating shareholder value, such as investment in

repositioning, consolidation, and perhaps opportunities in commercial-like

near-adjacencies. The sector will want to build confidence in the investment

community that strategic investment can create strong risk-adjusted returns.

Given the opening, companies for which defense is only a portion of their

business may decide to disruptively invest in the sector.

Challenge 5: Talent

The defense sector does not have a value proposition for attracting and

retaining the best talent. At the same time, some of the skills required to

compete in the current and future environment are quite different from those

resident in defense companies today. During the past 10 years, some of the

business skills that characterized successful companies in the last downturn

appear to have atrophied.

Given these five challenges, how should the sector respond? We believe that

the following five prescriptions—although not exhaustive—will help

companies position themselves in 2013 for success through the current

downturn and beyond.

Prescription 1: Focus Your Value-Creation Strategy

It is often said that strategy is more important during a downturn, given that

the lack of a rising tide of sector growth makes it more challenging to present

an attractive picture to the investment community. As we look at industry

participants today, some are “hunkering down” and others appear to have a

somewhat fragmented strategic focus, leading to dilution of organizational

effort and, in some cases, confusion in the investor base.

It is best not to dilute effort by trying to execute too many strategies and

business models, and don’t hunker down to wait for the customer to steer

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you in the right direction. In the last downturn, companies that hunkered

down fared worst, and usually ended up exiting the sector.

Do pick one value creation strategy (or very few), and focus the company and

investment community in this direction. The good news is that there are a

number of potentially attractive value-creation strategies possible today,

many of which have a proven track record. For example, during the last

downturn, companies like Northrop Grumman and Lockheed Martin (or

their forebears) created significant value by consolidating excess capacity;;

similarly, General Dynamics created value by recycling assets across

segments.

The optimal strategy (or strategies) will vary by company situation,

capabilities, and segments served, and may also vary by business unit.

Management will want to choose, and choose quickly;; we expect that large

strategic moves could begin in 2013, as perhaps previewed by the attempted

BAE–EADS merger.

Prescription 2: Don’t Miss the Opportunity to Invest in Things That Matter

An industry inflection point is a catalyst to shift a company’s strategy and—

equally important—the capabilities that support the strategy. Don’t wait to

identify those capabilities that matter, and don’t spread the effort too thin by

trying to be “world-class” at everything you do. Given your chosen value-

creation strategy, do consider which few capabilities will truly differentiate

your company.

As an example, investing in commercial capabilities—fixed-price

development, product-line management, and value-based pricing, among

others—can help address evolving customer requirements like the demand

for increasing speed of development and fielding. This will put the company

in a good position to serve not only the core business but near-adjacencies as

well.

Boeing is one company that has recognized this. Two of its largest military

programs sell modified versions of commercial aircraft to the U.S. Defense

Department: the 767-based tanker (to the Air Force) and the 737-based P-8 (to

the Navy). Boeing has also acquired a number of companies that make

disruptive systems, such as unmanned aerial vehicles. Collectively, these

actions have enabled Boeing to compete in the defense sector more affordably

and nimbly than some of its competitors.

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Prescription 3: Consolidate Dramatically and Invest for Future Growth

The defense sector is undergoing the kind of correction that happens once

every 20 or 30 years. It is hard to overstate the extent of the downturn. At

some defense companies, however, wishful thinking persists. Some believe

they will find the fast-moving stream in this otherwise stagnant water. But

there is no fast-moving stream. The market is already down by a third in

terms of acquisition dollars, even before a possible sequestration. Costs must

be cut.

But don’t get mired in focusing on the “wrong” costs. Areas such as

discretionary spending and IR&D are important to address, and can provide

near-term relief, but they will reduce costs only by a few percentage points—

far below what is needed. Also, avoid loading the base with marginal work—

it only dilutes the enterprise’s focus and makes it more difficult to transform

cost structure in the long run.

Do reduce capacity by focusing on structural and systemic costs such as

facilities and the expenses associated with them (such as direct and indirect

labor and supplier networks). Doing so will require painful decisions, but

without it, there is no real future for portions of the sector—for customer or

company. Finally, reinvest some of the proceeds in capabilities that will

differentiate you for future growth, as discussed above.

Prescription 4: Lead from the Top and with Decisiveness

In growth markets, it is often helpful to move decision making closer to the

front line, where managers have the most direct contact with the day-to-day

needs of customers. In a downturn, though, decision making needs to be

more centralized and more direct, in part because difficult decisions will be

required and “self-amputation” is an unnatural act.

Don’t underestimate the challenge that the current environment brings.

Among the biggest regrets of leadership during the last downturn were not

acting quickly enough and not making hard personnel decisions early.

Rethink the role of the corporate core in order to elevate decision authority,

and define clearly the value that corporate headquarters provides across the

enterprise. It will also be important for the C-suite to take a more direct role

in the day-to-day business of the company, notably attacking costs and

changing personnel who are not suited to managing through a downturn.

Prescription 5: Develop and Reward the “General Manager”

Much of the defense sector over the past two or three decades has been

program-centric. That is, the customer—to a large extent—has acquired

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programs rather than products, and thus companies have tended to evolve

into portfolios of programs. Given such an environment, the best program

managers have logically advanced to senior leadership positions.

Although this has served the industry reasonably well when program

execution has been the coin of the realm, it has not necessarily rewarded

distinctive business leadership skills. Across much of the sector, the concept

of the general manager (as opposed to the program manager) has declined,

although this is less true in multi-industry companies than in pure defense

companies.

The same leadership skills that have characterized success over the past

decade or two will not necessarily apply during a downturn. In a period of

industry contraction, business leadership skills are at least as important as—if

not more important than—program management skills. In fact, this is an

opportunity to create a new value proposition for attracting and retaining

distinctive talent.

Conclusion

The coming year will be important for the sector to ensure customer

capability and a healthy sustainability for the future. The operating models,

capabilities, and leadership approaches that have worked over the past years

will need to shift if companies are to reposition themselves well. Certainly,

customer and industry will have to work together to achieve this. For both

sides, higher levels of agility, fortitude around cost controls, and innovative

thinking regarding new bases of competition will be fundamental

underpinnings for a successful future.

Dr. Erich M. Fischer

Partner

[email protected]

Marty Bollinger

Senior Partner

[email protected]

mailto:[email protected]

mailto:[email protected]

booz & company 2013 defense industry perspective

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