How the Defense Industry Will Deal With the Coming Cuts

The people who run the U.S. defense industry aren’t real big on metaphors, and yet many of them subscribe to a distinctly metaphorical view of how military spending ebbs and flows. The prevailing view in the sector is that Pentagon spending occurs in waves that crest every 20 years or so, after which demand gradually recedes for a long time before once again beginning to build.

This pleasingly cyclical pattern is a pretty good description of how the postwar period has unfolded, but it looks nothing like the pattern of U.S. military outlays during the previous 150 years. However, because none of the executives running defense companies today were around for the previous 150 years, the “wave theory” of military demand seems more plausible than it really is. In fact, being engineers and financial types, they have unconsciously transformed the metaphor into a mechanistic model for the sector, complete with business cycles and inflection points.

The reality is that no business driven by military threats can ever be predictable, and the waves of rising and receding demand seen over the last six decades were random rather than cyclical. Think back to the dangers that drove surges in demand — North Korea’s invasion of the South, Sputnik, Vietnam, the Soviet invasion of Afghanistan, 9-11 — and you realize almost all of them were colossal surprises. So the notion that we know where military spending is headed today is fallacious. A year from now it could be dropping like a rock due to a fiscal crisis, or it could be surging to unprecedented levels due to new threats.

But nobody wants to work in an economic sector with that amount of uncertainty, so the wave metaphor will continue to shape company strategies until the next big shock comes along. What the metaphor tells corporate planners today is that Pentagon spending is headed into a prolonged decline deeper than the Obama Administration is willing to admit, but not so deep as to undermine the premise that companies should remain focused on supplying the military.

So leading defense contractors have begun implementing the standard playbook of measures developed in previous defense downturns for dealing with softening demand. Discretionary spending is being cut. Under-performing business lines are being sold. Under-utilized workers are being furloughed. And cash is being conserved for the coming rainy days. Oops — I guess I’m beginning to mix my metaphors.

What isn’t being discussed, though, is large-scale mergers or diversification out of defense. Big mergers are precluded by the way in which the industry over-consolidated in the last downturn, leaving a handful of look-alike military conglomerates at the top of the sector. Pentagon acquisition chief Ashton Carter told industry leaders earlier this year that the government would not approve full-up mergers between first-tier contractors because it would diminish competition in a business where there are already too few qualified players for any given product.

As for the “D-word” — diversification — that is almost universally viewed as a dangerous mistake by defense executives and the investment community. Nobody thinks demand is going to soften to a point where diversification out of defense makes much sense, and few industry observers believe military contractors have the skills needed to compete in commercial markets. That view isn’t really borne out by recent experience — GD’s Gulfstream unit is performing well in business jets and Boeing’s surging commercial aircraft unit is run largely by alumni from its defense business — but the bias against diversification remains strong.

So the basic disposition of most defense contractors today is to cut costs, conserve cash, and not throw Wall Street any curveballs. Things will get worse before they get better, the thinking goes, but in the end the U.S. government will remain by far the biggest customer for military goods in the world and eventually a new threat will come along to stimulate demand.

That could prove to be the best course of action, but it’s also possible that taking the wave metaphor too seriously has led to a lack of imagination among executives about what the future might hold. One reason military outlays have ebbed and flowed within predictable limits since World War Two is that the United States has been the dominant global economic power throughout the period. For instance, in the year 2000, the U.S. accounted for roughly a third of global economic output and a third of global military spending.

However, things have broken down badly since then, in a way they never did previously while the current crop of senior defense executives were pursuing their careers. Specifically, U.S. military spending has surged to a staggering 46 percent of the global total while the nation’s share of world output has plummeted to only 23 percent. Clearly, the divergence in these two measures of power cannot persist indefinitely, and one way the gap is likely to be closed is by sizable cuts to the defense budget.

A notional idea of how big those cuts might become can be derived from looking at the current size of the federal deficit. About 40 percent of federal outlays are being borrowed, so if the government was to pursue a balanced budget by pro-rating the Pentagon’s share of deficit savings to its proportion of the budget, then about $300 billion would need to be cut annually from current military spending. I’m not saying the government should or shouldn’t do that, but corporate planners ought to consider the possibility it might happen given the depth of reductions in previous defense downturns.

Obviously, companies couldn’t cope with cuts on that scale using the standard panoply of tactical measures, so something more strategic would need to be contemplated — especially given the propensity of the political system to cut technology outlays first and furthest, while trying to avoid reductions in spending on people. Even the biggest companies would have to contemplate the kinds of moves seen in the post-Cold War defense depression, when well-known names like Hughes Aircraft, Ford Aerospace and E-Systems disappeared. They would also have to think more seriously about diversification into non-defense business lines, since buying deeper into a rapidly shrinking defense sector would not be viewed as a wise way to deploy capital.

Few senior executives today are thinking in these terms, because market trends do not yet warrant such rash measures. Faster economic growth might alleviate fiscal pressures, or new threats might deflect calls for defense cuts. But if demand weakens markedly, it isn’t hard to see which companies would be most willing to change their strategies.

Boeing has plenty of options to pursue in the commercial transport sector if it begins to doubt there is a future in defense. The company has already seen a quarter-trillion dollars in future military business disappear as a result of program cuts by defense secretary Robert Gates, so senior management must know how hard it will be to maintain a balance between military and commercial revenues in the company’s business mix. General Dynamics has a smaller stake in the commercial aircraft sector, but the structure of incentives and management culture driving its senior executives stresses shareholder returns over product loyalty, so it would undoubtedly jump ship if defense no longer offered the prospect of sizable profits (it already did that once in the early 1990s).

And then there is Northrop Grumman, which manages to combine the smartest CEO with the most demanding board of directors in the defense sector. Northrop CEO Wes Bush is saddled with the challenging task of improving shareholder returns during a period of softening demand, and he has already demonstrated a willingness to reorient the whole enterprise if conditions warrant. With naval shipbuilding and much of the company’s technical services business already divested, it seems likely Bush wouldn’t hesitate to jettison other businesses that failed to perform — or get into businesses that offered the prospect of steadier returns.

The other big players in the sector currently show little willingness to diversify away from defense. Lockheed Martin has the strongest military franchises in the business and has been gaining market share at the expense of competitors. Raytheon is the most ubiquitous subcontractor in the sector and is steadily growing the portion of its sales derived from foreign military customers. BAE Systems looks poised to lead sector consolidation because its European shareholders reward revenue growth more than U.S. shareholders do. These three companies will probably be the last to consider large-scale diversification.

But that doesn’t mean they never will. There’s only one customer that matters in the defense business — the government — so if that customer decides to buy less for a long time, the only way military contractors can make up the difference is to do other things. Foreign military customers aren’t likely to cover the shortfall in sales caused by a downturn in domestic defense demand because the Europeans are cutting military outlays faster than America and the Middle East is in turmoil.

Thus, the big U.S. defense companies may have to get a good deal more creative about how they do business in the future to continue meeting shareholder expectations. Investors may grumble about the dangers of diversification, but in the end what they care about are earnings. They’ll take them wherever they can find them, so that’s where defense companies will go.

Loren Thompson, a member of the Breaking Defense Board of Contributors, is a defense consultant and analyst at the Lexington Institute and author of the Early Warning blog.