Managing a downturn: How the US defense industry can learn from its past - May 2013
1Kevin Dehoff,John Dowdy, andJohn NiehausManaging a downturn:How the US defense industrycan learn from its pastAs more than a decade of war nears an end,and the US budget faces acute challenges,the Department of Defense (DOD) is cutting itsinvestments in the development and pro-curement of modernized capabilities. A “downcycle” in military spending is in fact wellunder way, its depth and length uncertain. Yet,the investment budget has been throughsimilar downturns before. Companies that actdecisively to capitalize on today’s realities,rather than merely doing “less of the same,” willbe rewarded in the near term. Firms thatadjust to the cycle will also be better positionedover the long haul, when the cycle in alllikelihood reverses as a necessary wave of newprograms and investments to modernizeCompanies that assertively managed their portfolio thrived in the last budgetdownturn. The same strategy will work again today, but companies must be mindfulof the new context.the military emerges. Positioning the industry tocreate more affordable mission solutions,pursuing new pockets of growth, and activelyreshaping the portfolio of businesses areprincipal strategies for both industry and govern-ment in the face of the downturn.The cycle turnsSince World War II, the United States has beenthe world’s largest defense customer by far.US wars in Iraq and Afghanistan in the pastdecade accelerated spending, driving itto historic heights and increasing America’sglobal share of a $1.55 trillion market to44 percent—more than six times the share ofChina, the second-leading spender.1Brian Stauffera e r o s p a c e & d e f e n s e p r a c t i c eA P R I L 2 0 1 3
2However, the winding down of two wars and acutepressure to reduce the national debt burdenafter the country’s biggest financial shock sincethe Great Depression have cast a long shadowover the US defense budget. Planned reductions inDOD spending will exceed $487 billion overthe next ten years, and there may be more cutsin store.2Even before these developments, the downcycle was already well under way: since the fiscalyear 2008 “peak,” the DOD’s investmentaccounts—procurement and research, develop-ment, test, and evaluation—have declinedby 25 percent. Combine these trends with thelatest pressures, and it is clear that the DODis facing a protracted budget “trough.” Althoughmany uncertainties remain, preparing fora sharp reduction in DOD investment-accountspending is prudent (Exhibit 1).The budget contraction is increasingly visible.Since 2008, several major defense programshave been canceled and others restructured,including the Future Combat System (FCS),Combat Search and Rescue Helicopter (CSAR-X),Expeditionary Fighting Vehicle (EFV), Presi-dential Helicopter (VH-71), Next-GenerationCruiser (CG-X), Armed ReconnaissanceHelicopter (ARH), and Global Hawk Block 30Exhibit 1McKinsey on Defense 2013Managing downturnExhibit 1 of 6The industry should prepare for a signiﬁcant cyclicaldecline in defense spending.US investment (RDT&E1 and procurement) spending$ billion, measured in constant 2013 dollarsPeak-to-peak cycle timePast FutureCAGR,3 2010–18 = –5%(estimated)Trend growth rate of 1%22 years1Research, development, test, and evaluation.2McKinsey projections assume $800 billion in total reductions to Department of Defense discretionary funding for 2011–21(the midpoint between the president’s budget and the Budget Control Act of 2011’s “sequestration”), with 50% of $800 billion incuts coming from procurement and RDT&E.3Compound annual growth rate.Source: Ofﬁce of Management and Budget; US Department of Defense; McKinsey analysis300FY1950FY1960FY1970FY1980FY1990FY2000FY2010FY202025020015010050018 yearsInvestment spendingLong-term trend lineIndicative investment cycle2–50%–51%–40% to –50%
3the Berlin Wall, then–secretary of defenseWilliam Perry encouraged the industrial base toconsolidate, and consolidate it eventually did,with many household names merging or disposingof their defense assets. But more recently,the DOD has made it clear that it does not supportanother round of mergers given the currentdegree of consolidation in the industry, at leastamong the biggest prime contractors.3As a result, industry and government leaders aregrappling with difficult questions: what can topmanagement do in the face extraordinary externalpressures? What can the DOD do to encouragethe right choices in industry? We argue that a goodprograms, to name just a few. Further,the DOD has taken action to shift more riskto suppliers.These changes have already begun to affect thedefense industrial base. Multiples for the sharesof pure-play defense firms began to declinein 2006—well before the financial crisis. Sharesof pure-play firms now trade at the lowestmultiples in 20 years, and significantly belowthose of firms that also have commercialbusinesses (Exhibit 2).In the last down cycle in defense spending,following the end of the Cold War and the fall ofExhibit 2McKinsey on Defense 2013Managing downturnExhibit 2 of 6Defense companies suffered in the downturn,especially pure-play ﬁrms.The recent economic downturn hashad a negative effect on all aerospaceand defense companiesPure-play defense companieshave been hit much harder thandiversiﬁed playersNEV/EBITA1 multiplesMedian multiple, 1975–2011Decline in NEV/EBITA multiplesDifference between 2008–10 average and1980–2007 average, %Industryhistoricalaverage:10.4–30.6Pure-playdefense2–13.1Aerospaceand defense4–18.6Diversiﬁed3–5.3S&P1NEV: net economic value; EBITA: earnings before interest, taxes, and amortization.2Pure-play defense players: BAE Systems, General Dynamics, L-3, Lockheed Martin, Northrop Grumman, and Raytheon.3Diversiﬁed players: Harris, Honeywell, ITT Exelis, Oshkosh, Textron, and United Technology Corporation.4Aerospace and defense players: ATK, Boeing, Goodrich, McDonnell Douglas, and Rockwell Collins.Source: McKinsey Corporate Performance Analysis Tool (outliers have been removed)1981 1986 1991 1996 2001 2006 2011151050IndustryS&P 500
4place to begin is with an assessment of thestrategies of the defense companies that emergedthe strongest from the post–Cold War market.Lessons learned from the previous cycleBetween 1985 and 1998, the DOD reducedspending on a scale similar to that of today. DODinvestment fell 52 percent from peak (1985) totrough (1995), and it did not start to recover untilthe late 1990s. We analyzed the publiclyannounced strategies and high-level indicatorsof financial performance of major defensefirms through the cycle. The analysis is necessarilyqualitative, as the huge wave of consolidationthat characterized the end of the cycle made theperformance of individual firms obscure.In general, we can say that industrial companiesresponded in one of three ways:• Pursuing comprehensive business repositioning.Led by their corporate center, these companiesassertively restructured their portfolio ofbusinesses. They moved early and decisively tobuild at-scale advantage in new businesses (oftenthrough acquisitions), as well as in businessesthey retained. Some exited other businesses. Bythe end of the cycle, several firms in thiscategory had portfolios of businesses that borelittle resemblance to their lineup ten yearsearlier. These firms embraced the down cycleas an opportunity; further, they were ina better position than others to benefit when thecycle turned up again, after September 11, 2001.Broadly speaking, these firms generated superiorfinancial performance throughout the cycle.• Optimizing the core franchise. These companieslargely maintained their corporate strategy(making fewer acquisitions and divestitures) andput to one side the question of which businessesthey should be in. They improved their corebusinesses by consolidating and rationalizingexcess capacity. When the market began togrow again, they had to optimize their portfolioof businesses under less-than-optimalconditions; some had to make acquisitions athigher valuations, while others had to sellunderperforming businesses at low prices. At theend of the cycle, these companies’ mix ofbusinesses was largely the same as before.• Weathering the storm. These companies did notconsolidate operations or overhaul theirportfolios. Instead, they focused on overcomingprofitability problems and turning aroundtroubled programs, as well as winning pivotal—but relatively scarce—large new programs.To be sure, all companies devoted some effortto performance improvement and costreduction, but these firms led the way. Theirsuccess and survival depended heavily onwinning major programs and waiting for thedown cycle to reverse.Our key finding from the analysis is unambiguous.Active portfolio management was the singlemost important strategy of defense companiesin the last down cycle. In a period of deepuncertainty, buyers and sellers came together toproduce extraordinary consolidation, andboth parties were successful. Defense companiesthat managed their portfolios to system-atically divest assets generated substantialsurplus cash, rapid stock appreciation,and sizable dividends, which resulted in thehighest total returns to shareholders.Buyers who purchased the right assets werepositioned for competitive advantagein the next up cycle, rationalizing industrystructure and excess capacity while acquiringdistinctive capabilities. Conversely, firmsthat waited to move paid the price: their eventual
5MA was done at higher multiples, and thegreater expense of these moves hobbled theirfirms for years afterward.Investors rewarded active portfolio managementwhere it created value. Many investors main-tained a longer-term perspective and believed thatthe defense market would rebound; theyalso believed that consolidation would provideeconomic benefits to all stakeholders by reducingexcess capacity and lowering fixed costs.By 1997 (two years after the trough), most of theavailable assets had been acquired, andgovernmental encouragement for additional majormergers effectively ended. By that time,however, defense-equity multiples had expanded50 percent (Exhibit 3)—well before the upcycle was fully under way.The new strategic agendaThe strategy that emerged from the last cyclewill likely be just as valid in the currentExhibit 3Clinton administration Bush administration Obama administrationPast FuturePrevious periodof defense-industryconsolidationMcKinsey on Defense 2013Managing downturnExhibit 3 of 6Multiples for defense stocks rose considerably from the startof the last consolidation.Public defense-equity multiples, EV/EBITDA1Mean historicalmultiple: 7.5x1EV: enterprise value; EBITDA: earnings before interest, taxes, depreciation, and amortization; averageEV/EBITDA multiple based on Merrill Lynch Defense Index.2Projection based on McKinsey’s defense-equity pricing model and investment-account projections.3The “Last Supper” was a 1993 meeting between the secretary of defense and defense-industry executives, in whichthe industry was urged to consolidate.4Discounted relative to historical multiples and comparable with those during the previous consolidation.Source: Merrill Lynch Equity Research; McKinsey analysis121988 1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 201811109876543201McKinsey’s defense-equity pricing model2Actual EV/EBITDABerlin Wall fallsDot-com zenithSeptember 11Financial crisis“Last Supper”3 Current period ofdiscounted defense-asset valuations4
6Exhibit 4McKinsey on Defense 2013Managing downturnExhibit 4 of 6The global defense sector is highly concentrated today.Revenue of the top 100 defense companies worldwide,1 %Top 10 companies100% =Next 90 companies16 6 6Number of primecontractors19 46 100% of top 100companiesthat still existin 20101Revenue ﬁgures are expressed in constant 2010 dollars; 100% indicates the total defense-related revenueof the top 100 companies in the industry.Source: Defense News 100; US Budget GDP Deﬂator; US Department of Defense19916139$126 billion20004060$192 billion20104258$419 billionone. However, we should note four differencesbetween today and the early 1990s:• Today’s downturn will probably last longer.Fiscal pressure—caused by the mounting federaldeficit and complicated by persistent growthin mandatory entitlements—will likely prolongthe reductions in defense spending.• Absent dramatic changes in threat levels, newdefense programs will be few and infrequent.• Primary growth in demand will be outsidethe United States and largely concentrated in thedeveloping world.• The potential for consolidation and industryrationalization is much more limited today. The10 largest companies now command 58 percentof the total revenue of the top 100 players,compared with 39 percent in 1991 (Exhibit 4).Additionally, the number of players in majordefense systems is much smaller—in missiles, forexample, there are 3 at-scale competitorstoday, in contrast to 13 in 1990.To deal with these complications and to sustaina strong industrial base for the future, the DODand its suppliers might consider a strategywith three bold steps: reimagining the businessportfolio, the winning play in the last cycle,
7will be vital, but so too will be developing the rightcapabilities to build products that the customercan afford. And firms will need to take stepsto find new areas of growth, especially in overseasmarkets. We argue that this three-prongedstrategy can help firms prevent the precipitousearly drops in financial performance that thesector experienced in the early 1990s and can posi-tion the sector for strong performance inthe future.AffordabilityIndustry and government have long struggledto check the relentless growth in the costsof developing and producing modern weaponssystems. Many measures have been triedonly to be abandoned; costs continued theirinexorable rise. Recently the DOD hastaken steps to break the back of this problem;it now seeks to cap costs by stating what itcan afford to pay—and making clear its intentionnot to pay more. Consider the US Air Force’sLong-Range Strike Bomber program; Air Forceleadership has said that this program’ssuccess requires an average procurement unitcost of not more than $550 million.4Explicitly capping costs to emphasize afford-ability is a new step, one that the industryacknowledges but for which it is ill prepared.5 Tosucceed in this new world, industry shouldfirst commit to the new rules, includingthe “must cost” nature of defense contracts andthe implications for the relationship with itscustomer. Firms must then transform theirbusiness model, capabilities, and culture to buildproducts that the customer wants and canafford, and ensure that cost cuts stick. If firms canget this right, it will not only enhance theirchances of winning a contract but also improvethe probability that the program receives itsfunding in the first place.To make the shift to affordability, firms must makea sweeping array of changes in their businessmodels, and especially the following capabilities(Exhibit 5). They should start with the changein the customer relationship. What the governmentseeks, and the nation needs, industry isnaturally obliged to deliver. The governmenthas made changes in acquisition policy ina way that places much of the burden of changeon the industry—and shifts more risk to it.Industry leaders should extend a helpfulhand while simultaneously making it clear thata true peer-at-the-table partnership withgovernment is required to craft affordable,high-value mission solutions.
8But industry must also recognize that, withthis change, government is asking for theindustry’s help; it sees that it cannot lead aloneand needs the industry’s commitment toenable transformation. For example, it is industryand not government that is in the best posi-tion to judge what is technically feasible in a giventime horizon and cost range.Industry should engage government and makeclear its belief that the relationship should change.In our recent survey of industry leaders, manysaid that they are hoping for greater transparency,simplification and acceleration of processes,and more open dialogue and collaboration withthe government customer (see “Defenseoutlook 2015: A global survey of defense-industryexecutives,” on mckinsey.com). Industry leadersshould extend a helpful hand while simultaneouslymaking it clear that a true peer-at-the-tablepartnership is required to craft affordable, high-value mission solutions. In practice, this mightmean a requirements-setting process that looksmore like commercial business models, withmechanisms that enable industry to effectivelychallenge ideas that are inconsistent withcost and schedule constraints. It is both reasonableand essential for industry to aim for a partner-ship of equals in the formulation of complexmission solutions.This imperative is equally critical for government.While avoiding industry capture is important,it is also true that only a collaborative approachExhibit 5McKinsey on Defense 2013Managing downturnExhibit 5 of 6Defense companies must transform their business models.From . . . To . . .• Protracted, ambitious developmentwith uncontrolled scope• “Generational leaps” in technology• Rapid, time-bounded development• Incremental, product-line approachto technology• Life-cycle-requirements outlookProduct development• Arm’s-length relationships withmarginal level of trust• Poor communications and lackof transparency• “Conspiracy of hope” that leads tocost and schedule overruns• A true partnership with high level of trust• Joint problem solving, with each sidecontributing its distinctive expertise• Mutual and objective assessment of probablecosts and time-certain schedulesCustomer relations• Designed around optimisticallyhigh volumes• Long production runs• Flexible, but designed for lower volumes• Agile production cyclesProduction andmanufacturing• Organizational structure shapedby large platforms• Heavy infrastructure and allocated supportcosts absorbed by business unit• Lean infrastructure and support driven bybusiness requirements and affordability• Talent management to develop leaders andmaintain critical skillsOrganization• Optimized for suppliers’ capabilities• Fixed supplier base• Reactive approach to suppliermanagement• Optimized for cost, ﬂexibility, and speed• Agile and global supplier strategy• Collaborative supplier relationshipsSupplier-relationshipmanagement
9can lower costs while continuing to driveinnovation. Government simply doesn’t have theinformation it needs to effectively managedevelopment and procurement costs, and theonly way to get it is through increasedcooperation. By appropriately managing incen-tives, government buyers can capture thesecollaboration benefits.Product development is at the heart of theaffordability transformation. Productdevelopment must change, moving away from aprotracted process that aims for the mostexquisite technical solutions and toward rapidand time-certain development models, inwhich affordability and risk reduction are criticalperformance parameters.Production and manufacturing systems thatare designed around optimistic volumeprojections and long production runs should beshelved in favor of low-volume (and thusmore realistic) flexible manufacturing approacheswith shorter production cycles.Supplier relationships used to be formed almostentirely on the basis of suppliers’ ability to meetmission requirements. In the future, suppliers’ability to meet cost targets and deadlines, and theirflexibility in rapidly accommodating changes inprograms, will be just as important. Frequentchanges in programs also mean supplierrelationships should become more collaborative,so that suppliers can better anticipate requestsfor changes. Many traditional defense supplierswill likely find this very challenging. Defensecompanies will have to establish a global base ofsuppliers, casting a wide net to improve com-petition and add redundancy.Organizations today are often structuredin units corresponding to the company’s legacyacquisition programs. These programs,contracted on cost-plus terms, encourage abloated infrastructure and inflated costs.In the new world of affordable systems, com-panies will need not merely to cut thesecosts but to restructure the organization in waysthat match the customer’s needs. This willalso serve them well in adjacent andinternational markets, as we discuss below,where the old and expensive platform-centric structure will likely prevent the firm frommoving with the needed agility, deftness,and entrepreneurialism.The shift to affordability will also mean bigchanges in roles and responsibilities. For example,
10industry program managers will need to raisetheir game. With so many programs plagued withburgeoning costs and hidden risks to theenterprise, program management must reduceoverhead and get better at identifying andmitigating a comprehensive set of project risks.(Government too should improve skills inthis area, as we explain in “Project managementin defense: The essential capability,” onmckinsey.com.) More broadly, critical technicaland leadership skills can erode rapidly in adown cycle, as the most experienced engineers,scientists, and program managers retire andattracting the next generation of engineers andleaders can be difficult. Moreover, the shiftto affordability requires a profound change incorporate culture. Taken together, theseissues bespeak the need for a redesign of thetalent strategy at many defense companies.GrowthWith the US defense budget declining and fewernew franchise programs cropping up, compa-nies must sharpen their ability to identify growthopportunities. Although almost all defensesectors will shrink, companies should scour thelandscape for the relatively high-growth seg-ments that remain. They should seek those thatare suitable for investment and provideopportunities to build an advantaged positionat scale.The search should start by considering the shift ofnational-security focus and the associatedreallocation of budget. Most notably the “pivot tothe Pacific” emphasized in recent revisionsto the National Military Strategy prioritizedcertain investment capabilities and force-structure levels. Intelligence, surveillance, andreconnaissance systems; undersea andsurface ship capabilities; long-range strikeaircraft; strike missiles; missile defense;electronic warfare; and capabilities needed tooperate in sophisticated anti-access/area-denial threat environments are in demand, whilecapabilities needed to support deployedground forces are on the wane.Firms can also look overseas for growth. Manyemerging markets were unscathed by the financialcrisis and stand to benefit from growingeconomies and intrinsic defense-investmentcapacity. (For more on the opportunitiesin these markets, see “A bright future for India’sdefense industry?” and “Strategy, scenarios,and the global shift in defense power,” onmckinsey.com.) This has no doubt prompted theDOD to emphasize exportability in its recent
11Better Buying Power 2.0 initiative. This is anunambiguous growth opportunity.However, the challenge of international defensemarkets is often underestimated. Offsetrequirements, national politics, complicationswith local partners, and significant differences inUS trade law relative to international com-petitors add complexity. Perhaps most important,there are often four or more competitors bid-ding on the most lucrative opportunities ratherthan the two or three customarily involvedin DOD procurement. In this light, joint ventures,alliances, and partnerships with internationalcompanies may provide an answer. A partner withmarket access and critical capabilities, includ-ing an understanding of the customer and productand technology know-how can help US firmsgain a foothold in these markets and increase theirmarket share on economically attractive terms.Portfolio managementAs noted, US defense-company equity multiplesare at generational lows—and they could dip lowerstill, given the potential for further reductionin the DOD’s investment accounts and for broaderfiscal crisis in the United States. While thelow multiples no doubt produce sleepless nightsfor CEOs, the flip side is that companies havean opportunity to acquire other defense assetsnow at what may be seen as bargain pricesby the end of the decade.We also see other opportunities to activelymanage the portfolio. Many companies have builtup portfolios over the past 20 years withoutsufficient attention to rationalizing them. Asa result, they contain a mix of some very healthybusinesses and others that are challenged.With little chance for more megamergers thatwould remove unproductive capacity fromthe industry, companies are going to have to do itthemselves, either by selling less attractivebusinesses, substantially restructuring them, orspinning them out. We have begun to seesome of this already, with Northrop Grummanspinning off its shipbuilding business inMarch 2011 to form Huntington Ingalls Industries,and SAIC announcing its intention to splitinto two separate companies. We can expect tosee many more such moves to rationalizeand restructure portfolios.For both acquisitions and sales, a sober examina-tion of the competitive landscape, marketdynamics, and the future environment is essential.While it is almost impossible for defensecompanies to time acquisitions anddivestitures perfectly, those that are wellprepared—and ready to deal—willlikely benefit most.