Monday, May 05, 2014

Budget Cuts and the US Defense Industry

As US conflicts in both Iraq and Afghanistan come to a slow end, aggregate global defense spending is declining, which is unsurprisingly, being accompanied by declining revenues among the largest firms in global defense contracting.  In a recent report issued by Deloitte, a prevalent global financial advisory firm, this decline was explored in great detail.  The report highlights the need for defense contracting firms to assess the new global market place and to make associated changes to market strategies for the upcoming years.  One of the most notable and obvious changes to the market for defense contractors is a dramatic dip in US defense spending due to realities arising from recent budget cuts implemented by the Budget Control Act of 2011.  The DoD, who is by far the largest consumer for global defense contractors, will continue to spend less in coming years, meaning that contractors will need to not only find new consumers, but also make changes in the services and wares which they will offer.

In terms of revenue, the effects of budget cuts and sequestration forced by the aforementioned Budget Control Act, are a large source of the decline in revenue of both foreign and domestic defense contractors.  Global defense contractor revenues for 2013 are expected to drop for at a rate of around 2.5%, and this trend is expected to continue for the next several years barring a dramatic change in spending.  Domestically, firms are experiencing an even greater decline in revenue at around 3.3%, where these contractors are dependent to a greater extent upon the DoD as a main consumer.   Although defense spending by the DoD is significantly declining, other nations, that admittedly account for a much smaller share of the global defense consumption pool, are increasing spending, these include India, China, Russia, South Korea, Brazil and Japan.  Going forward, these countries will certainly be places where defense contractors will want to go in order to find new business, although they will hardly be able to replace the US defense department in terms of consumption size.  This is evidenced by the fact that according to 2012 statistics, the US accounts for nearly 40% of aggregate global defense spending.

In changing the approach for defense contractors in terms of what services and products will be developed and provided, the companies will need to narrow their focus more towards programs which countries, especially the US, will continue to value as important amid budgetary cuts.  In large part, these programs will be next generation intelligence, surveillance and reconnaissance technologies.  The ability to collect, analyze and react to real time information offers the upper-hand to militaries of countries who are able to implement advanced technologies on the battlefield.  Additionally, the US pivot to the Asia-Pacific region has emphasized a shift away from services and weaponry associated with ground warfare and more towards naval and air force capabilities.  By concentrating increasingly on developing technology for force projection in these areas, contractors can take steps to mitigate revenue losses.  Cyber Security will also continue to be of great importance for national defense strategies and developing technologies that provide national defense and intelligence departments with an advantage in cutting edge cyber defense capabilities will require greater attention and spending.  By first finding a new consumer base to replace lost business with the US, and refocusing production and offered services, defense contractors will be able to adapt to new realities in the global market place.

In the past there has been a precedent for additional ways which defense contractors can cope with lower defense spending.  Following the conclusion of the cold war in the early 1990s a similar period of lower defense budgets was experienced among defense contractors, where these companies were forced to deal with a significantly smaller consumer base.  Large cut backs in personnel for these contractors was seen as firms were forced to increase revenue and profits on a per worker basis by shrinking the workforce and increasing productivity.  Similar steps have already been seen among industry giants like Lockheed Martin and Northrup Grummon, where these defense and aerospace corporations have seen a significant drop in revenue, while enjoying an increase in profit margins.  Using Lockheed Martin as an example, the near 4% dip in revenue has somewhat been accompanied by steadily increased profit margins, where a large increase in per worker income has supplemented the overall drop in aggregate business numbers.  This leaner and more productive work force is the result of relying increasingly on automated production to avoid having to pay expensive human labor forces.

To say that these large defense and aerospace corporations are in trouble on an existential level would more than a vast overstatement on the current state of affairs in the industry.  As referenced earlier, this is certainly not the first time that defense contractors have been forced to make changes resulting from a much small consumer base.  Going forward changes in development strategies and finding new consumers must occur, but to this point, it seems that the biggest companies in the industry have already taken significant steps to ensure that they are ahead of the curve on changes to associated consumer markets.  Firms and corporations that are smaller in nature will more than likely be the area of the market where drawbacks in spending will be most detrimental to business.  The tremendous amount of red tape that is associated with acquiring defense contracts, especially through the DoD, places the largest firms a decided advantage in receiving contracts, and a leaner consumer market will only exacerbate this reality.  This is seen through the new data deal worth $500 million recently won by Lockheed Martin Australia.

Going forward it will be interesting to see how new business strategies for defense contractors effect labor markets and research and development aims for defense contractors.  Jobs in the defense industry are politically charged and politicians will go to great lengths to protect jobs in their associated districts.  The political drama that will take place in Washington and new strategies implemented by defense contractors as a result will offer insight into the overall direction of national defense priorities domestically and internationally going forward.  Although contractors will again have to change the way they do business going forward, to say that they companies, especially the largest among them, will be existentially threatened by budget cuts would be a false assumption.  Those who adapt best to these new realities will obviously be at a distinct advantage and their business successes will be telling to see who has altered business models most effectively in the coming the years.

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