Defense Industry Ponders Where It Goes From Here

The Pentagon was declared the big winner of the massive federal budget bill that Congress passed for fiscal year 2014. The spending bill approves $497 billion for the Defense Department, or about the same as in 2013. The Pentagon gets an additional $85.2 billion for war expenses — about $5 billion more than it requested.

Weapons manufacturers are not celebrating, though. An immediate reprieve from steep cuts is good news but there is still considerable anxiety among CEOs about their companies’ future. Industry sees long-term decline, global trends that could upend the arms business, and a Pentagon customer that is becoming consumed by internal budget battles and is reluctant to commit to big-ticket programs.

Defense industry soon has to “develop creative strategies and business models or risk catastrophic failure,” said Ben FitzGerald, senior fellow and director of the technology and national security program at the Center for a New American Security. CNAS just launched a six-month study that will probe the future of defense industry through 2030.

The industry is entering a period of change, and defense companies’ fortunes are tied to broader market shifts and government policies that could have lasting impact, FitzGerald told National Defense. One obvious example is the dramatic rise in technological know-how in commercial industries whereas the defense sector has seen beset by failed programs and Cold War-era buying methods that take 10 to 20 years on average to deliver new weapon systems.

The industry has been chasing “trendy niches” such as cybersecurity and unmanned aviation, but does not have deep insight into where the opportunities really lie. The Pentagon traditionally communicates its long-term needs to defense contractors, but since the onset of sequester and a budget crunch, the priority has been short-term survival. “The Defense Department doesn't have a clear sense of its own investment priorities and therefore industry isn't sure what it should be doing,” FitzGerald said.

CNAS convened a group of defense industry CEOs, think tank analysts and academics — called Task Force on Strategy, Technology and the Global Defense Industry — that will debate how defense companies ought to rethink their business relationship with the Pentagon and how they might expand into other markets. Their findings will be released in June at CNAS' annual defense conference.

The industry's fate largely depends on Pentagon decisions on how it will modernize U.S. forces to confront future threats. In its Cold War heyday, the Pentagon was the leading developer of cutting-edge technology and still commands the world’s most advanced military force. But at the same time, it has created self-defeating mechanisms that quash innovation and fail to capitalize on available opportunities, analysts have noted. Undersecretary of Defense for Acquisition Frank Kendall said the United States is still way ahead of competitors in areas such as fighter aircraft and submarines. But there are segments of the weapons market such as ballistic missiles and cruise missiles where “other people are doing quite well compared to us,” Kendall said Jan. 16 at a CNAS gathering. In electronic warfare, other countries are catching up with the United States, he said. U.S. space systems, he added, are increasingly vulnerable.

How companies might regain the innovation edge and whether they should become less dependent on the Pentagon are top issues of concern to industry, FitzGerald said. “Many consequential technologies today exist outside the defense industrial base.” The defense sector has not come to grips with the outsize importance of non-defense technology, nor has it figured out how to diversify successfully into commercial business, he said. “The challenge is to understand how to piece together markets.” U.S. companies have to prepare for a much more globalized defense business, said Fitzgerald. That will be one of the questions to be probed in the CNAS study. “Will industries in Asia or South America rise to compete against U.S. and Europe in the global defense market?” he asked.

International competition is at the front and center of the industry's agenda, said Ellen Lord, president and CEO of Textron Systems, a technology conglomerate that has both commercial and defense businesses.

“Today, we see challenges,” Lord said Jan. 15 in a speech at the Atlantic Council, a Washington think tank. “We see long-term budget decline. We see excess capacity in markets and strong international competition,” she said. “As a result we see shifts in strategies.”

For some companies such as Textron, the ticket to growth is to tap commercial technology to build modern weapons systems that do not take decades to develop. The company has launched a commercially funded surveillance light-attack manned aircraft and a spy drone that could become litmus tests for the Pentagon’s willingness to depart from traditional defense programs in order to save money and innovate.

“We identified gaps in the future and made a bet on what is needed,” said Lord. “We think the customers will follow.” The Pentagon has yet to prove it is serious about change, said Lord. Many current contracting opportunities, she said, remain “cost-plus” deals whereas commercial companies like Textron would prefer fixed-price competitions where they would have an edge. “We fall into the trap of having to meet specific requirements,” he said. “We are not incentivized to leverage commercial technology because it's too hard given the rigor of our acquisition environment.”

Industry groups worry that uncertainty about where the defense business is going could weaken companies across the board. “Noting the fiscal and budgetary constraints our country faces in the coming years, we must understand the impacts and plan for how the defense industry can be sustained in a way that keeps our technological edge and support to the war fighter,” Arnold L. Punaro, a retired Marine Corps major general and chairman of the National Defense Industrial Association, wrote in a letter to members.

Punaro has recruited Brett Lambert, former head of industrial policy at the Defense Department, to help develop a “strategy and plan for the defense industrial base.” Lambert will oversee a team of industry officials who will provide “fact-based perspectives on how we can best manage and preserve our critical industrial capacity,” Punaro said.

Kendall, the head of defense acquisitions, warned the industry to brace for several years of fiscal pain. The omnibus budget that spared the Pentagon from cuts in 2014 protects readiness and personnel accounts, but not research and procurement, said Kendall at the CNAS forum. “The 2015 cuts will be worse than ’14, and we don’t know what happens after that,” he said. A major problem for industry is that there are entrenched and competing interests within the Pentagon that do not see eye-to-eye on how to balance short-term needs against far-out investments. “Until we can get our force structure down, research, development and acquisition will take more cuts,” said Kendall. “That’s just math.”

Defense Secretary Chuck Hagel has said the Pentagon is going to have to choose between quantity or quality as budgets get tighter. It can have a large force with older equipment or a smaller but more technologically advanced one. Kendall pointed out that the Pentagon has a historical tendency to hold on to force structure. “We have internal debates about the needs of DoD and how we balance risk.” In the meantime, he said, “I encourage industry to make investments. I hope that companies out there are doing that.”

Wesley Bush, CEO of Northrop Grumman Corp., said it behooves industry leaders to persuade Congress to stop a mindless pursuit of budget savings without considering the consequences. Federal research and development, as a percentage of the nation’s economy, is at its lowest point since the 1950s, Bush said at the CNAS gathering. “We are making a profound mistake by cutting R&D as we deal with profound budget issues.”