In the Eye of a Perfect Storm: Current State of the U.S. Defense Industry U.S. Chamber of Commerce S

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In the Eye of a Perfect StormCurrent State of
the U.S. Defense Industry U.S. Chamber of
CommerceSpace Enterprise CouncilWashington
D.C.November 18, 2004Pierre A. ChaoSenior
Fellow and Director Defense-Industrial
Initiatives202-775-3128pchao_at_csis.org
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Beyond Goldwater-Nichols Phase Two

• Building Capabilities for 21st Century Missions
• Is DoD properly organized for homeland
  security, stability operations,
• counterterrorism and WMD counterproliferation?
  
• Organizing the Joint Force for Global,
  Regional, Country and
• Functional Operations
• Designing a United States Government
  Appropriate for 21st
• Century Challenges
• Do for the interagency process what
  Goldwater-Nichols did for the
• planning and conduct of military operations
• Building a New Defense Acquisition Process
• A Zero-based Assessment of the Defense Agencies

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Beyond Goldwater-Nichols Phase Two

• Assessing Joint Officer Management and Joint
  Professional
• Military Education
• Building Capabilities for New Domains of
  Warfare
• Is DoD properly organized, trained and equipped
  for space and
• cyberspace?

In a parallel but closely related effort, CSIS
will conduct a National Guard and Reserve study
that will address the viability of the Total
Force concept in the 21st century
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THE LANDSCAPE
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1990s Perfect Storm
Cyclical Changes
IMPACT
Pressure from deficits, call for post-Cold War
peace dividend, Procurement Holiday, cut
programs/stretch out
Budgets
Horizontal mergers Exit from industry Increased
risk
Structural Changes
End of Cold War
Rapidly changing unpredictable security
environment, changing military requirements,
fewer new program starts
Technological Change
Vertical mergersDisconnect
IT revolution spilling over into
defense,increased acceleration of technology
cycles
Export marketsIntl competition
Globalization
Of the economy, technology and labor
Demise of the conglomerate, stick to your
knitting, defense run as business
New Philosophy of Business
Exit from industry
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The Result Was Dramatic Consolidation...
1990
1988
1980
1982
1984
1986
1992
1994
1996
1997
1998
1999
Source SDC, DACIS DMA
First Wave
Second Wave
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Resulting in 3-Tiered, Barbell-Shaped Industry...
The Rest 37 of 2003 DoD Prime Contract
of DoD Prime Contract s
Third Tier
Third Tier
6-100 28 of 2003 DoD Prime Contract
Second Tier
Second Tier / Mezzanine
First Tier
Big 5 35 of 2003 DoD Prime Contract
Big 5
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The Next Side of the Storm
Post- Cold War
Rapidly changing, unpredictable security
environment
New Philosophy of Business
Demise of the conglomerate, stick to your
knitting
Defense Investment Spending
Deficits
Peace Dividend
1985
Technological Change
IT revolution spilling over into defense
Globalization
Of the economy, technology and labor
Acceleration of Change
Speed adopted as a strategic advantage by
commercial sector and military
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Internal Pressures On Defense Budget Increasing.
. . The Operations and Maintenance Death
Spiral Still With Us
OM BA as Percent Of Total DoD Budget

• Old equipment increasingly more expensive to
  maintain
• Iraqi War costs adding to the operations
  maintenance bill

Source CBO, DoD 2005 Greenbook
10
More Internal Pressures on the Defense Budget

• Growth in Personnel Costs ramping up as well
• End Strength Growth
• Rising Health Care Costs

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Investment Accounts the Bill Payer, Again
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This is a Budget That is Buying Fewer Things
1985 2005 Defense Budget Outlays
(Constant 2005 ) 421 Bn 450 Bn Military
Personnel Active 2,152,000
1,386,000 Reserves
1,078,000 863,000 Troop
Strength Europe 300,000 111,000 Major
Military Installations 221 120 OM
Percentage of Tot. DoD 29
38 Proposed Procurement Fixed-Wing
Aircraft 585 188 Combat Vehicles
2,031 190 Ships/Submarines 24
8 Tactical Missiles
32,714 5,702
Source DoD, Defense Foreign Affairs Handbook,
Janes, AIA With anticipated 25B Iraq War
Supplemental
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And Has Limited Ability to Start New Platform
Programs
Combat Aircraft
Ships/Subs
Missiles (Non-Strategic)
Combat Vehicles
Source DoD, Janes Defense, FAS, Global
Security, DMA Database
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However, Where There are Increasing Numbers of
Programs We See Increasing Numbers of Suppliers

• Budget dollars enhance the health of companies,
  its the number of new programs that drives the
  health of the industry

UAVs
Tactical Radios
Battlespace Awareness Systems
Major Info Networks
Source DoD, Janes Defense, FAS, Global
Security, DMA Database, Teal Group
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• Impact of the Elections
• Assume Congress remains Republican
• Hard for Kerry Administration to cut defense
  spending, easier for Bush (only Nixon could go to
  China)
• Missile defense most vulnerable to changes in
  administration (Republican Congress will dampen
  radical change)
• Who is next SecDef? Reset vs. recapitalization
  vs. transformation?
• Both parties have to respond to fiscal realities

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HOW TO CREATE VALUE IN THIS ENVIRONMENT?
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Industry Has Four Key Levers To Create Value
Material Inputs Labor Defense overhead Cost of
capital
Cash margins (return)
Value Investors7.2-8.5x EBITDA 11.4-14.1x PE
Facilities Machinery/Tools Land Goodwill
Invested Capital
Value
Defense Budgets Commercial Aero Exports
Growth (Revenues)
GrowthInvestors8.2-10.1x EBITDA 14.2-18.2x PE
TechnologyPatents/IPHuman Capital Brand
Competitive AdvantagePeriod
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Defense Industry Margins Have Improved BUT
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The Industry Does Not Operate in a Vacuum

• What are the alternative investments when you
  consider the defense sector?

Source CSFB survey
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Defense Returns Improved, But Lowest Relative to
Peers
Notes 1) CSIS Defense Index comprises 36
publicly-traded companies with majority revenues
derived from US defense business. (2) SP
Sub-sector constituents accurate back to 1994
composition held constant for years 1980 to 1993.
Sources FactSet, SP Compustat, Energy
Information Administration, CSIS Analysis
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• Conventional Wisdom
• Defense industry should have lower returns than
  peers because
• Defense industry has lower risk
• Pentagon pays for everything
• RD and assets paid for
• Industry has long term contracts and the FYDP
• No one allowed to fail

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Reality is Far Less Predictability...
Department of Defense Future Years Defense Plans
500
450
400
Projected
350
Actual
300
250
200
Source "Defense Budget for FY2003 Data
Summary", March 29, 2002, Stephen Daggett and Amy
Belasco, Congressional Research Service.
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As Demonstrated by Volatility Measure...
Industry Revenue Volatility 1980-2003
SP Software Services
Publicly Owned Electric Utilities
DoD Proc RDTE Outlay
SP Pharm Biotech
SP Tech Hardware
SP 500
0
SP Capital Goods
10
20
30
40
50
60
70
Revenue Volatility Index
The Defense Market As Volatile As Biotech/Pharma
Notes 1) CSIS Defense Index comprises 36
publicly-traded companies with majority revenues
derived from US defense business. Boeing
Military revenues have also been included here.
(2) SP Sub-sector constituents accurate back
to 1994 composition held constant for years 1980
to 1993.
Sources FactSet, SP Compustat, Energy
Information Administration, National Defense
Budget Estimates for FY2004, CSIS Analysis
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Apparent Risk-Reward Disconnect in the Defense
Business...
Industry Revenue Volatility versus Average
Operating Margin 1980-2003 (weighted by revenue)
25.0
SP Pharm Biotech
SP Software Services
20.0
Publicly Owned Electric
Utilities
15.0
Average Operating Margin ( of revenue)
Target Margins Given the Risk
SP 500
SP Tech Hardware
10.0
SP Capital Goods
DoD Proc RDTE Outlay
Risk-Reward Disconnect in the Defense Market
5.0
0.0
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
Revenue Volatility Index
Sources FactSet, SP Compustat, Energy
Information Administration, Congressional
Reports, CSIS Analysis
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Policy Realities Leave Industry With Few Levers
to Pull
Industry Revenue Volatility versus Average
Operating Margin 1980-2003 (weighted by revenue)
25.0
SP Pharm Biotech
SP Software Services
20.0
Publicly Owned Electric
Glass Ceiling in Margins, Difficult Politically
To Change
Utilities
15.0
Average Operating Margin ( of revenue)
SP 500
SP Tech Hardware
10.0
SP Capital Goods
DoD Proc RDTE Outlay
5.0
0.0
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
Revenue Volatility Index
SOWork the Volatility/Risk Side of the
Relationship
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Consolidation Used To Generate Stability...
Industry Revenue Volatility versus Average
Operating Margin 1980-2003 (weighted by revenue)
25.0
SP Pharm Biotech
SP Software Services
20.0
Publicly Owned Electric
Utilities
15.0
Average Operating Margin ( of revenue)
SP 500
SP Tech Hardware
10.0
CSIS Defense Big 5 (unweighted)
SP Capital Goods
CSIS Defense Other (unweighted)
DoD Proc RDTE Outlay
5.0
0.0
0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
Revenue Volatility Index
Industry Achieved Stability Via Acquisitions
Bought Revenue/Backlog
Sources FactSet, SP Compustat, Energy
Information Administration, Congressional
Reports, CSIS Analysis
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Industry Strategies Generally Limited

• Limited by growth in budgets- Acquire it (hit a
  limit as well)

Growth (Revenues)

• Cut costs- Cut investments - Eventually hit
  the margin glass ceiling

Cash margins (return)

• One of few areas with running room- Continue
  to shrink invested capital keep capx low,
  acquire and consolidate, give capital back

Invested Capital
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Fewer Opportunities, Low Returns..Cut IRD
Get out of ST, Acquire it instead, Outsource it
Sources FactSet, SP Compustat, CSIS Analysis
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Shrink The Cold War Asset Base...
Sources FactSet, SP Compustat, CSIS Analysis
Notes 1) CSIS Defense Index comprises 36
publicly-traded companies with majority revenues
derived from US defense business. (2) SP
Sub-sector constituents accurate back to 1994
composition held constant for years 1980 to 1993.
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Financial Response to the Policy and Market
Realities...
Sources FactSet, SP Compustat, Energy
Information Administration, Congressional
Reports, CSIS Analysis
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Industry Returned To the Line Via Acquisition
and Cuts in Investment/Capital ...
Industry Revenue Volatility versus Cash Flow
Return on Investment (HOLT CFROI) 1987-2003
(weighted by invested capital)
MSCI Pharm Biotech
MSCI Software Services
SP 500
CSIS Defense Big 5
CSIS Defense Other
HOLT CFROI
MSCI Tech Hardware
MSCI Industrials
Sources FactSet, SP Compustat, Energy
Information Administration, Congressional
Reports, CSIS Analysis
Revenue Volatility Index
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HOW TO ADDRESS THE MARKET?
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Defense Supplier Relationships Are Changing.

• Outsource/exit component and subsystem work
• Concentrate supplier relationships
• Push risk down

• Acquire defense IT and electronic companies
• Increased involvement in supplier selection

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From A Return Standpoint, Second Tier Does Better
Notes 1) CSIS Defense Index comprises 36
publicly-traded companies with majority revenues
derived from US defense business. (2) SP
Sub-sector constituents accurate back to 1994
composition held constant for years 1980 to 1993.
Sources FactSet, SP Compustat, Energy
Information Administration, CSIS Analysis
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Second Tier Does Better on CFROI As Well
Notes 1) CSIS Defense Index comprises 36
publicly-traded companies with majority revenues
derived from US defense business. (2) SP
Sub-sector constituents accurate back to 1994
composition held constant for years 1980 to 1993.
Sources FactSet, SP Compustat, Energy
Information Administration, CSIS Analysis
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Relationships With Customers Are Changing.
Government
LSI/SoS
Platform/ System Prime
Platform/ Systems
Major Subsystems
Major Subsystems
Subsystems
Subsystems
Components
Components
Materials / Commodities
Materials / Commodities
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KEY QUESTIONS
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• Strengthening the Core/BGN Issues
• What should be done in government versus
  industry?
• What is the definition of a healthy industry?
  What are the metrics you use?
• How do you align incentives to get the behavior
  you want?
• How well is the G-N acquisition structure
  working?
• Space specific questions