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By Aoyu Bai

Facing budget cuts and new threats, the defense industry finds itself rethinking its traditional business model.

The F-22 Raptor, produced by Lockheed Martin (NYSE:LMT), is the pride of the United States Air Force. As the most sophisticated fighter in service, it functions as both a ground-attacker and an air superiority fighter while its innovative stealth capabilities cloud it from the enemy’s radar. While its sleek design has ensured that its image appears on many calendar and posters, seeing the expensive fighter in actual combat may be much less common.

The U.S. Defense Secretary Robert Gates’s Pentagon budget in April 2010 eliminated funding for many flagship development programs, including the F-22, which is to be phased out in 2011. With a congressional ban on the export of the aircraft, the development of the cheaper F-35, and a lack of Russian and Chinese counterparts, the Raptor’s $143 million per unit price tag could not be justified. Despite the lengthy and secretive development process, it appears as though only 187 of these aircrafts will ever appear in service.

Western defense contractors such as Lockheed Martin and Raytheon (NYSE:RTN) belong to a peculiar industry. During times of economic uncertainty, such as war, they have been able to outperform the S&P 500. Instead of the boom-bust business cycle, the defense industry depends on the government’s perceptions of foreign threat. Traditionally, as long as firms churned out what generals wanted, they appeared invincible. However, now they can no longer rely on the government to keep it afloat. Austerity and unconventional wars are beginning to present threats to the industry that will demand fundamental changes, the likes of which it has never seen.

In the years following the September 11th attacks, defense firms saw their shares rise as U.S. military spending climbed. Public fear and two subsequent wars drove the military’s demand and the S&P 500 Aerospace & Defense Index (S5AERO). But with withdrawal of combat troops from Iraq and the war in Afghanistan winding down, today’s geopolitical landscape is much less lucrative than almost a decade ago.

President Obama is eager to show that he is tough on wasteful, or even nonessential, spending. Thus watering down expensive projects is a natural thing to do. America has a military budget almost the size of the rest of the world combined. While it has been fighting two wars, a significant portion of the spending has been dedicated to ambitious research and development projects. However, unlike during the Cold War, America’s current threats do not come from tanks and jets, but rather suicide bombers and improvised explosive devices. Not surprisingly, stealth fighters are much less capable of protecting ground troops from bombs held together by duct tape. Thus defense contractors’ most prized products are being rendered useless.

Aside from low demand, warships and aircrafts become more and more expensive with each generation. With normal technology, once it becomes more prevalent, costs and prices come down due to competition and lower production costs. But, with military equipment, advancements only drive the prices higher. Military contractors have difficulty building up economies of scale, since their products cannot be sold to just anyone. Furthermore, the necessity of secrecy reduces the ability of firms to build upon existing technology and often forces them to develop parallel projects from the beginning. Redundancy reduces efficiency. Lastly, while Apple (NASDAQ:AAPL), a non-defense company, bears the risk that its next iPhone development project may run over-budget, governments usually shoulder the cost of over-budget defense projects. It just so happens that defense firms often underestimate the cost of development.

Research and development, especially for military equipment, bear the risk of technological barriers. Projects are often delayed due to the inability of developers to find solutions to overcome limitations of existing technology. Delays not only raise costs, but also risk the final product being outdated before it is completed. Thus, even the development phase may demand upgrades. In the end, the product can come out much more expensive than predicted. Consequently, order sizes decrease, hurting whatever economies of scale firms hoped to develop.

Facing lower demand, large defense contractors are in a rush to cut costs. This July, Lockheed Martin offered voluntary buyouts to directors and vice presidents, hoping to cut overhead costs and bureaucracy. It is also considering selling two business units and restructuring two more in preparation for the slowdown. At the same time, Northrop Grumman (NYSE:NOC) is considering selling off its shipyard to General Dynamics (NYSE:GD). Both firms saw their shares decline since April along with Raytheon and Lockheed Martin.

General Atomics, a smaller defense firm, appears to be on the right track. Their Predator drones, which are Unmanned Aerial Vehicles (UAVs), are much cheaper and more expendable compared to manned jetfighters. Flying at low altitudes like a remote-controlled toy plane, they are extremely useful for reconnaissance and precision strikes. Their counterinsurgency capabilities make them vital to the Afghanistan-Pakistan theatre. However, even this presents a serious flaw: the dependence on communication technology. Controlled by a team from a distant base, drones keep satellites busy transmitting commands and data back and forth. If those satellites ever go offline due to an attack from an advanced enemy, ground forces will be left vulnerable. This opens up a niche for new and innovative firms to compete with industrial juggernauts such as Boeing (NYSE:BA) and Lockheed.

Cybersecurity is a new area of vital strategic importance. Countries are constantly trying to hack each other’s networks for highly sensitive information. While a successful attack can yield top-secret strategies or blueprints for military projects, failure usually results in some media embarrassment and unpleasant diplomatic conversations, if any. The opportunity lies in the fact that anyone can write a cybersecurity program, and thus many small niche players have emerged, ranging from those who find vulnerabilities to those who mend them. The Pentagon alone has over 7 million computers. Coupled with the computer of high-profile politicians and the number of countries with capabilities to launch malicious cyberattacks, this is a very large market. Accenture recently estimated this market to be around $80 billion to $140 billion.

This recent development compels large defense contractors to behave like tech companies, acquiring small competitors for their specialties and talents. In June, Boeing offered to buy Argon ST Inc. [STST], a C4ISR (Command, Control, Communications, Computers, Intelligence, Surveillance, and Reconnaissance) firm for about $775 million in order strengthen its foothold in the market. As Argon ST only had a market value of $535 million, Boeing was not afraid to pay a premium. Not to be outdone, Northrop and Lockheed are scanning the horizons for acquisitions as well.

An inherent business advantage is available in cybersecurity. Compared to military equipment, software can be rendered outdated in a matter of months. Thus these firms have no worries about keeping themselves busy. At the same time, computer programs can easily be patched so the firms bear less risk of expensive and time consuming projects that lead to no results, like Boeing’s experience when it found out that the US government selected Lockheed’s submission to the F-35 project over its own.

However, the newest enemy is not the only enemy. Just because jetfighters are not useful now does not mean they never will be. As lucrative as cybersecurity is, contractors cannot afford to abandon their traditional projects. With the Iraq War winding down, governments may find even less need for tanks and planes. But defense firms cannot find less need to develop them. In Canada, Stephen Harper proudly outspent previous Liberal governments on defense. However, with a large deficit and the conclusion of the Afghanistan commitment, the Canadian Forces may once again find itself wishing for more. But with Arctic sovereignty becoming increasingly important, the navy could use a few more ships.

Another problem with the path towards cybersecurity is the fact that programming does not have the same clout with politicians as manufacturing. The cancellation of F-22 production faced strong congressional opposition because their manufacturing provides jobs to 44 states. While building tanks and ships can be seen as blue-collar and patriotic, the government will be much less hesitant about pulling the plug on a lab of computer engineers when their uses seem to diminish.

Under the current conditions, a prudent investor may choose to stay away from defense firms. Though domestic demand may slow, exports to the Gulf Arab states are set to increase within a year or so. The United States this week announced arms sales worth nearly $60 billion to Saudi Arabia while anticipating similar ones to other Middle-eastern countries due to the instability in the region, especially with regards to Iran. At the same time, negotiations to sell the F-35 Joint Strike Fighter to Israel and Japan are likely to be completed soon. With these deals on the way, defense firms-- especially Lockheed-- should not be shorted. But in the longer term, there is only so much America is willing to sell to other countries. When western governments begin to tighten their budgets, defense firms will be in no position to grow. In an era of weak demand and industry restructuring, investors should adopt a wait-and-see approach in the defense sector.

Lockheed Martin, the world’s largest defense contractor, proudly displays its motto: “We never forget who we’re working for.” Indeed, with national security at stake, the defense industry is too important to fail. For decades they were cushioned from economic downturns by the government’s desire for national security. Yet now, during turbulent economic times when cash-strapped western governments can no longer afford all the latest gadgets for their troops, defense contractors must nonetheless find answers to the ever-evolving threats abroad. Facing these new challenges and opportunities, they, more than anyone else, must never forget whom they’re working for.

Disclosure: No positions

Source: Thoughts on the Future of Warfare