The Health and Financial Standing of the Defense Industry

The fourth session of the national security industrial base working group focused on the current internal health and financial standing of the industrial base itself. Discussion was as always according to the Chatham House rule, with Robert Trice of Lockheed Martin and Pierre Chao of Renaissance Strategic Advisors making brief presentations to initiate the conversation.

A number of points came up in discussion:

• That the U.S. national security industrial base has greatly downsized, with the aerospace and defense sector now employing somewhat more than 600,000 workers in contrast to numbers twice as large in the fairly recent past
• That this sector is a high-wage and high-export sector for the U.S. economy
• That profit margins are often only about half of what is commonly believed due to certain costs that cannot be billed to the government and related matters

In fact, the sector averages profit margins of about 9 percent, less than many industries that tend to achieve margins in the teens. Whether this is a reasonable and fair state of affairs or not is debatable. Some suggest that companies with a sure customer and dependable market (the U.S. government) shouldn’t be entitled to as much profit as those operating in a more unpredictable marketplace, whereas others counter that the U.S. government is hardly a consistent customer or an easy customer to work with.

The national security industrial sector is overall not unhealthy. But stocks are relatively underpriced, perhaps, as Wall Street has already incorporated expectations about declining defense budgets into the valuations of virtually all defense firms. And there are other concerns as well (to which we return below).

The current DoD interest in moving back to fixed-price contracts causes some a good deal of worry.  uch an approach was attempted two decades ago with unfortunate results for the industry. But there are mitigating factors. For example, most of today’s top defense executives cut their teeth in the industry during that previous downturn, so they are experienced at dealing with tough periods. Also, the industry has numerous survival skills. For example, greater use of fixed-price contracts by the department may lead to higher bids for a given system (as contractors try to ensure that any unexpected cost growth will not prevent them from achieving a profit).

Many companies are showing greater interest in the most lucrative or least capital-intensive parts of the DoD acquisition agenda—service contracting, IT and cybersecurity, exports, and so on. By contrast, it may be harder to hold onto expertise in expensive production facilities.

Some argued that the “big 5” and other larger firms are likely to find ways to survive the coming expected downturn. By this argument, the greatest fallout is likely to affect certain subcontractors (the most vulnerable of which are hard to identify in advance—that is, unless “revolving door” restrictions are relaxed or circumvented so that customers and industry can talk to each other more easily). 

Others worry about the primes too, for a number of reasons:

• the vicissitudes of defense spending levels,
• increasing burdens from regulation and oversight,
• the difficulty and cost of starting large new production lines,
• the difficulty of turning profits based on R&D and prototyping,
• demographic trends in the defense workforce (with many experienced workers retiring en masse), and
• the uncertainty of attracting new talent into a business that may not be as likely to produce new systems in the future as in the past. A case in point: for the first time in the history of aviation, the United States currently does not have a manned aircraft program in the development phase. 

In light of all the above, one consistent message from the group was that greater communication—and clearer guidance—from the Pentagon towards industry would serve the interests of all. The Gates Pentagon, through Under Secretary Carter and others, has moved in this direction but substantially more effort as well as a sustained effort would be beneficial. This situation underscores the ongoing need for gatherings like the current Brookings working group, among other initiatives.