Much as the U.S. National Defense Strategy has been lauded, it looks increasingly like it’s dead before it even departs the Department of Defense. The 3-5 percent annual total spending growth needed to properly resource the strategy appears improbable, and so there is a looming gap that will shape contractor behavior and strategies in the coming year.
How the gap between resources and strategy is closed is a central issue for 2019. It’s highly unlikely that the DoD would opt to take an entirely different track in its assessment of the global security challenges the U.S. confronts. The Army, Navy and Air Force have all loudly signaled that they need larger-size forces to address challenges and deter adversaries and competitors. But the resource gap suggests that something will have to change.
Stock market investors partially figured this out in 2018, but the treatment by markets of large U.S. contractors has been uniform. Sales growth for the vast majority of defense contractors should be just fine for 2019-2020, but that’s a reflection of the largesse provided by Congress in the fiscal 2018 and fiscal 2019 DoD budgets. If the 2020 and 2021 budgets prove to be flat compared to 2019, that will translate to lower and possibly minimal sales growth in 2021-2022.
The mid-upper single-digit stock price declines evidenced so far in 2018 from year-end 2017 levels reflect recognition of this likely sales trend. However, there does not appear to be all that much differentiation, as far as investors are concerned, among the largest contractors. Valuations on consensus financial estimates and stock price behaviors have been uniform.
For contractors, the most attractive option will likely be to prepare to hunker down and retrench. This entails riding out the current sales wave, but then scaling back capital expenditures and beginning to plan for cost cuts and headcount reductions in the early 2020s. It may entail using even more free cash flow to shore up earnings per share through share buybacks; and in order to maintain operating margins, cuts to research and development could also be pursued. This may be the easiest path for managers to take, but it might also prove the riskiest.
Retrenchment strategies could be the riskiest because the DoD will be searching more fervently for ways to close the gap between resources and the challenges outlined in the National Defense Strategy. Opting to cut force structure and proceeding with current programs of record may simply widen the gap. Equally, trying to sustain current modernization programs and sustain force-size goals could cut readiness and again bring back the risks of hollow military forces.
The fervent search for sustained military capability will place even more emphasis on investments that increase the “productivity” of the DoD. In commercial businesses, productivity improvements can be made from investments in automation, reduction of overhead costs and the leaning out of processes. Technology plays a clear role, but so too does organizational and cultural change.
There are clear analogies for how this thinking could play out in the Pentagon. The thinking has been there, and there are already a number of initiatives underway, but the question is how they are resourced.
Contractor retrenchment may make incumbents even more vulnerable to loss of program and market share to current or new contractors who can offer the DoD the products and services to help close the gap. Minding the gap means taking more risk in 2019-2021 in terms of product and service development — and if not, possibly making decisions to exit business segments where risk could be highest.
Investment might entail some risk to operating margin, or redirecting cashflow from share buybacks to venture or partnership investments. A key to superior financial performance in the 2020s could come from taking share away from other contractors. The gap may make that a more fruitful strategy.
Byron Callan is a policy research expert at Capital Alpha Partners. He specializes in the defense and aerospace industries.