Opinion: Five Uncertainties Facing The Defense Market
It is that time of year again, when companies with calendar-year ends complete detailed corporate strategic plans that set the course for 2022 and beyond and will be the basis for management financial guidance. The detailed work on these plans is done, but a plan is not ironclad and must account for uncertainties and change. Defense markets are in transition, and open questions remain about which contractors are also in transition as well as whether their transitions will better prepare them for markets in the 2020s.
The first uncertainty is the U.S. Defense Department budget. Despite bipartisan support for the $25 billion increases that House and Senate authorizers have added to the National Defense Authorization Act for fiscal 2022, it remains to be seen when and at what levels appropriations will be passed. Congressional add-ons in fiscal 2022—if they are enacted—will cascade into out-year plans, particularly in operations and maintenance. A related budget uncertainty is how the Taliban victory in Afghanistan will affect future defense plans. The House Armed Services Committee reallocated Afghanistan-related funding to other spending for the Pentagon, but an unknown is how global terrorism could influence current defense plans.
Employee recruitment and retention has come roaring back as an issue for the defense sector after it successfully navigated the pandemic in 2020-21. One question is how vaccination and other COVID-19 mandates will affect employee retention, particularly in states or regions where there is popular opposition to these mandates and where employees have options to move to companies that do not or will not enforce mandates. Another issue remains the quest for skilled talent in trades, engineering and manufacturing. Assumptions have to be made on wage inflation and potential additional benefits that may be required to entice employees to stay.
Congress’ behavior is another factor that matters. The fiscal 2022 budget plus-up of $25 billion could be seen as a reflection of concern over strategic competition with China, though arguably many of the programs to which House and Senate authorizers added funding are less relevant to Indo-Pacific contingencies. If lawmakers see a pressing concern to deter China in 2022-25, little of that was reflected in increases. Had China been of more concern, funding boosts would have gone to precision weapons and missile defense interceptors, not mature tactical combat aircraft and large naval surface vessels.
The markups also again show an unwillingness to allow the Pentagon to divest older platforms that it believes are too costly to sustain and less relevant to future needs. The fiscal 2023 budget should reaffirm that the Pentagon wants to divest to invest, but there will be questions about whether Congress can restore those cuts and from where funds to do so will come. This has to be a judgment call.
Another central facet of strategic planning assessment should be what happens in the 2022 midterm elections. Consensus is that Republicans could gain a majority in the House, which would reintroduce split-party control in 2023-24. Given the passionate and partisan views on nondefense spending, one outcome is that not much will get done, as defense spending could be held hostage to these broader spending debates.
A fourth theme is whether new weapons, networks and concepts of operation emerge and are validated as ways to solve defense problems cost-effectively. In recent years, hypersonics and Joint All-Domain Command and Control (JADC2) have emerged as silver bullets of sorts, as have machine learning/artificial intelligence and digital engineering. The unit cost of hypersonic weapons is apt to relegate them to the category of strategic/limited use. JADC2 is forcing the Pentagon to confront data and proprietary systems architectures as well as software acquisition and development. In 2022-23, the Pentagon experimentation with unmanned systems and networks could entail significant changes to current programs of record if their value in combat can be validated.
The final factor is the dynamism of the competitive environment in defense. Some relevant sectors, such as space, are seeing a torrent of funding via special-purpose acquisition companies. Silicon Valley startups are maturing and getting better at moving the Pentagon beyond “technology tourism” as they build their capacities to execute on programs and influence the Defense Department and Congress. Large U.S. primes may focus intently on what their peers are doing, but they may risk seeing market share erosion from new entrants as well as from large established companies, like GM and Microsoft, that are pursuing defense work and from companies, such as Leidos, that are habitually identified as services but are pursuing defense product programs. The mergers and acquisition activity among some Silicon Valley entities, such as Anduril and Shield AI, is noteworthy, as is the creation of new defense companies by private equity firms, such as Arlington Capital’s BlueHalo, that are combining acquisitions.