2013 Defense Industry PerspectiveThe 20-year experiment with a pure-play defense industry is likely coming toan end. Once every two to four decades, the industry undergoes a majortransformation. The development of a formalized multisector industrial basein World War II and the consolidation into dedicated defense integrators inthe 1990s are two examples. Today’s declining budgets and changingcustomer requirements, and the increasing success of nontraditionalcompetitors such as Cisco, Eurocopter, and even Boeing CommercialAirplanes signal that the industry’s status quo is likely untenable. Someportions of the sector may become more stable by spanning defense andcommercial applications, while others may be more viable as arsenals ornational champions, where there is only one competitor per segment.Given that such inflection points happen perhaps once or twice in a typicalcareer, management teams in place today have a particular challenge: to leadtheir companies through an environment that few in their organizations haveexperienced. Indeed, few leaders may have been in management positionsduring the last industry inflection point.With the cost structure of the industrial base unsustainable, and withvaluations nearing probable lows, 2013 will be an interesting year for bothorganic and inorganic transformations. The recipe for success in this type ofenvironment can be distilled into a single imperative: manage the company asa business rather than as a collection of programs.We offer below a summary of our thoughts for success in the defense sectorover the coming year—specific challenges and specific prescriptions for howbest to address them.Challenge 1: Steep Decline in Federal SpendingAs 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 fewyears has been mirrored in many other countries. Given the lag betweenbudgets and outlays, some companies may still feel insulated from thedecline. But tackling the fiscal situation—both in the U.S. and globally—willrequire that defense spending be reduced further. Although we expect the
Page 2 of 6decline to be less severe than in the last two downturns—when U.S.acquisition funding declined roughly 50 percent from previous peaks—thereare more cuts to come.This means that the primary mechanism for shareholder value creation bymost defense companies over the past decade—growth in an expandingmarket—is no longer available. This new reality applies to both hardware-centric and services-centric companies. Creating value will require alternativemethods, some of which will be understandably unfamiliar to currentmanagement teams, given the length of time that has elapsed since theindustry as a whole invoked these methods.The spending decline also means that capacity—a lot of capacity—has tocome out to keep programs even moderately affordable. In the last U.S.downturn, from 1988 to 1995, capacity was reduced significantly across manysegments, including, for example, fixed-wing aircraft (approximately 20percent of production square footage). This was how companies managed tomaintain their customers’ buying power as well as create shareholder value.In fact, 30 large industrial companies exited the defense business during thelast downturn.Challenge 2: Evolving Customer RequirementsWe are more than 20 years past the end of the Cold War, yet many defensecompany capabilities are still built around the extreme customer intimacyand exquisite point-solution systems development that characterized theCold War era. Today, many threats are less predictable and tend to evolvemore rapidly. This shift has raised questions about whether the capabilitiessystems of the typical defense company are obsolete. Defense companiesneed faster development and fielding cycles to remain relevant for largeportions of their core markets.Challenge 3: The Rise of New CompetitorsNontraditional companies—Accenture, Airbus, Apple, Cisco, Dell,Eurocopter, and Pilatus, among others—have become increasingly successfulin the defense sector. Indeed, if you exclude Cold War–era systems, thesetypes of companies account for about 40 percent of U.S. acquisition spendingtoday for major hardware programs;; services spending is similarly split.Traditional defense companies, which are sometimes slower to deliver andmore expensive, have had difficulties competing against these newcompetitors, even in traditional “core” markets. These traditional companieswill need to determine whether they can compete in their core markets
Page 3 of 6without development of commercial-like capabilities and, if not, howcommercial-like capabilities can coexist with traditional defense capabilities.Challenge 4: Shareholder Suspicion Regarding Strategic InvestmentToday, much of Wall Street is treating the defense sector like an industry inirreversible decline, and recommending that defense companies forget aboutgrowth and focus on maximizing dividends. This investor mind-set has beenreinforced by share buybacks and dividend yields that in some cases rivalthose of utilities and tobacco companies—with the implicit message that thereis little rationale for internal strategic investment.Some of the sector has painted itself into a corner by setting shareholderexpectations for continued high dividend yields, rather than making the casefor alternative methods of creating shareholder value, such as investment inrepositioning, consolidation, and perhaps opportunities in commercial-likenear-adjacencies. The sector will want to build confidence in the investmentcommunity that strategic investment can create strong risk-adjusted returns.Given the opening, companies for which defense is only a portion of theirbusiness may decide to disruptively invest in the sector.Challenge 5: TalentThe defense sector does not have a value proposition for attracting andretaining the best talent. At the same time, some of the skills required tocompete in the current and future environment are quite different from thoseresident in defense companies today. During the past 10 years, some of thebusiness skills that characterized successful companies in the last downturnappear to have atrophied.Given these five challenges, how should the sector respond? We believe thatthe following five prescriptions—although not exhaustive—will helpcompanies position themselves in 2013 for success through the currentdownturn and beyond.Prescription 1: Focus Your Value-Creation StrategyIt is often said that strategy is more important during a downturn, given thatthe lack of a rising tide of sector growth makes it more challenging to presentan attractive picture to the investment community. As we look at industryparticipants today, some are “hunkering down” and others appear to have asomewhat fragmented strategic focus, leading to dilution of organizationaleffort and, in some cases, confusion in the investor base.It is best not to dilute effort by trying to execute too many strategies andbusiness models, and don’t hunker down to wait for the customer to steer
Page 4 of 6you in the right direction. In the last downturn, companies that hunkereddown fared worst, and usually ended up exiting the sector.Do pick one value creation strategy (or very few), and focus the company andinvestment community in this direction. The good news is that there are anumber of potentially attractive value-creation strategies possible today,many of which have a proven track record. For example, during the lastdownturn, companies like Northrop Grumman and Lockheed Martin (ortheir forebears) created significant value by consolidating excess capacity;;similarly, General Dynamics created value by recycling assets acrosssegments.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 largestrategic moves could begin in 2013, as perhaps previewed by the attemptedBAE–EADS merger.Prescription 2: Don’t Miss the Opportunity to Invest in Things That MatterAn industry inflection point is a catalyst to shift a company’s strategy and—equally important—the capabilities that support the strategy. Don’t wait toidentify those capabilities that matter, and don’t spread the effort too thin bytrying to be “world-class” at everything you do. Given your chosen value-creation strategy, do consider which few capabilities will truly differentiateyour company.As an example, investing in commercial capabilities—fixed-pricedevelopment, product-line management, and value-based pricing, amongothers—can help address evolving customer requirements like the demandfor increasing speed of development and fielding. This will put the companyin a good position to serve not only the core business but near-adjacencies aswell.Boeing is one company that has recognized this. Two of its largest militaryprograms sell modified versions of commercial aircraft to the U.S. DefenseDepartment: the 767-based tanker (to the Air Force) and the 737-based P-8 (tothe Navy). Boeing has also acquired a number of companies that makedisruptive systems, such as unmanned aerial vehicles. Collectively, theseactions have enabled Boeing to compete in the defense sector more affordablyand nimbly than some of its competitors.
Page 5 of 6Prescription 3: Consolidate Dramatically and Invest for Future GrowthThe defense sector is undergoing the kind of correction that happens onceevery 20 or 30 years. It is hard to overstate the extent of the downturn. Atsome defense companies, however, wishful thinking persists. Some believethey will find the fast-moving stream in this otherwise stagnant water. Butthere is no fast-moving stream. The market is already down by a third interms of acquisition dollars, even before a possible sequestration. Costs mustbe cut.But don’t get mired in focusing on the “wrong” costs. Areas such asdiscretionary spending and IR&D are important to address, and can providenear-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 transformcost structure in the long run.Do reduce capacity by focusing on structural and systemic costs such asfacilities and the expenses associated with them (such as direct and indirectlabor and supplier networks). Doing so will require painful decisions, butwithout it, there is no real future for portions of the sector—for customer orcompany. Finally, reinvest some of the proceeds in capabilities that willdifferentiate you for future growth, as discussed above.Prescription 4: Lead from the Top and with DecisivenessIn growth markets, it is often helpful to move decision making closer to thefront line, where managers have the most direct contact with the day-to-dayneeds of customers. In a downturn, though, decision making needs to bemore centralized and more direct, in part because difficult decisions will berequired 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 notacting 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 theenterprise. It will also be important for the C-suite to take a more direct rolein the day-to-day business of the company, notably attacking costs andchanging 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 beenprogram-centric. That is, the customer—to a large extent—has acquired
Page 6 of 6programs rather than products, and thus companies have tended to evolveinto portfolios of programs. Given such an environment, the best programmanagers have logically advanced to senior leadership positions.Although this has served the industry reasonably well when programexecution has been the coin of the realm, it has not necessarily rewardeddistinctive business leadership skills. Across much of the sector, the conceptof the general manager (as opposed to the program manager) has declined,although this is less true in multi-industry companies than in pure defensecompanies.The same leadership skills that have characterized success over the pastdecade or two will not necessarily apply during a downturn. In a period ofindustry contraction, business leadership skills are at least as important as—ifnot more important than—program management skills. In fact, this is anopportunity to create a new value proposition for attracting and retainingdistinctive talent.ConclusionThe coming year will be important for the sector to ensure customercapability and a healthy sustainability for the future. The operating models,capabilities, and leadership approaches that have worked over the past yearswill need to shift if companies are to reposition themselves well. Certainly,customer and industry will have to work together to achieve this. For bothsides, higher levels of agility, fortitude around cost controls, and innovativethinking regarding new bases of competition will be fundamentalunderpinnings for a successful future.Dr. Erich M. Fischer Marty BollingerPartner Senior Partnererich.firstname.lastname@example.org email@example.com