SIMI VALLEY, Calif. — As defense companies struggle to balance the interests of the military customers with those of shareholders, it seems the Pentagon needs to rethink how it buys or else risk sacrificing its technological edge.
The Pentagon can’t shut its eyes to the fact that a healthy bottom line for defense companies is in the best interest of the military and essential to ensure future capabilities, said Navy Secretary Richard Spencer, speaking on a panel at the Reagan National Defense Forum Saturday.
“I am an unapologetic capitalist and free marketeer,” said Spencer, who worked on Wall Street for 16 years. “One thing we need to be responsible for is the health of the industrial base. It’s a dance that has to be done. You’re out there with a fiduciary responsibility to buy the best gear in the most efficient, best way you can. Now you add in, ‘I have to help an industry in a certain area,’ or ‘I have to make the capital investments myself’ — it flies in the face of full and open competition. But we have to live with that to get gear.”
L3 CEO Mike Strianese pointed to his own company’s tactics when defense budgets were flat or declining during the last decade: funnel hundreds of thousands of dollars to share repurchases to ensure a particular return for investors.
“[That investment] wasn’t in tomorrow’s technology,” because there was no confidence or assurance from DoD that such an investment would result in business opportunities, Strianese said. “Simply, that was the only place to go for a number of years when the budget was contracting and shrinking, if you wanted to sustain your company and operate in this competitive market.”
Thankfully, as defense budgets have stabilized, so have earnings for the top companies. J.P. Morgan’s executive director for Aerospace and Defense, Michael Leskinen, estimated that the sector is valued at the top 5 percentile — a solid place to be, even if expansion will likely be modest. L3 has shifted its corporate investment policy from predominantly share repurchasing to acquisition and research and development.
Leskinen would like to see players that invest in internal R&D, or IRAD, get disproportionate amount of top line growth — meaning they get some means of an advantage from customers in competitions. But that is an example of discretion that DoD can’t easily take. While companies in Russia and China can often move faster infusing funds into companies, partly because they’re state owned or operated, the Pentagon can’t easily reward private sector investments without a specific contract or opportunity driving that investment.
Procurement restrictions also impede a company’s ability to replicate commercial best practices. Leskinen pointed to Boeing’s Partnering for Success model of negotiating with suppliers on key commercial programs — the 737 and 777 to name a couple — with the understanding that a better price could provide the supplier future opportunities. Such a model could trim costs for the P-8, a modified version of a 737, but Spencer confirmed it falls outside procurement rules on validated prices.
“Why can’t we take the mindset that we’re buying readiness? I don’t want to own parts in the bin. I want to buy readiness,” he said. “How the supply chain gets it there and does it, that’s the value they provide me.”
The biggest threat to U.S. technological dominance, according to DIUx Managing Director Raj Shah, “is candidly ourselves.”
“We’re fortunate we have a senior leadership team focused on modernization; the operators on the ground — they’re the most innovation people in the world. But what we do have is an incentives problem,” Shah said. “We have built a set of structures and rules that does not encourage speed. You have processes where you don’t get fired for going slow but you might get fired for making a small mistake.”
Furthermore, if the Pentagon along with Wall Street continue to look past the smaller startup companies developing future capabilities, unable to rationalize investment without a specific contract attached, the U.S. will fall further behind. If you look at all venture deals in the U.S. in 2015, 12 percent had an investor from China, Shah said. That’s up from 6 percent in 2010. In robotics specifically, 17 percent of funding is from China.
“You can make determinations of why,” Shah said. “But if we think things are going to be military relevant in the future, getting a seat at the table early, is a big deal. ...The challenge for us — we look at our economic arm and national security arm quite separately. Our adversaries don’t.”
Spencer made an analogy to Sputnik when describing the risk of falling behind in technology, saying U.S. overmatch is not as great as it used to be.
“We used to own this space,” he said. “And now, all of a sudden, we’re hearing the pitter patter of feet coming behind us.”