Podcast: Sizing Up the U.S. Defense Industrial Base
Despite the challenges facing companies supplying the U.S. military, analysts Byron Callan and Steve Grundman see signs of strength and evolution.
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Here is a a rush transcript of the January 26, 2022, Check 6 Podcast.
Jen Dimascio: Hi, and welcome to the Check Six Podcast. I'm Jen DiMascio, The executive editor for defense and space here with two guests. Steve Grundman, the principal of Grundman Advisory and a former deputy under secretary of defense for industrial affairs. And Byron Callan, a director at Capital Alpha Partners in Washington.
Jen Dimascio: They're both contributing columnists for Aviation Week. And recently in this first month of 2022 wrote about what might be in store for the US defense industrial base. So let's start off with a topic that's been on everybody's mind the last two years COVID. Already, the virus has led to production delays on numerous programs. How is omicron affecting manufacturers?
Steve Grundman: I appreciate you having us here, but I would defer in the first instance on this question to Byron who I think has written about it a bit more than I've even thought about it.
Byron Callan: Well, yeah, Jen, it's a good question because we're on the eve of another round of earnings and companies are going to be reporting their results for the quarter that ended in December. The interesting thing is it's probably not so much what happened on the fourth quarter, because I think at that point, people are probably dealing more with how the employees are coming back? What was the status of the vaccine mandates.
Byron Callan: But since then you've seen this blow off in the omicron variant of COVID and how that might have impacted January and more importantly, maybe February and March expectations. I suppose the good news here is that the data, at least in some parts of United States is showing that this is peaking. So it went up like a rocket. It may be coming down like a rocket too.
Byron Callan: It's not to say that we're done with COVID 19 and its impact. There could certainly be future variants, but I think people probably going into this set of earnings, management's had a lot of experience now in dealing with this and managing their expectations for workforce absenteeism because they're sick. And I think it's probably a wave that's cresting, but again, we'll really see that confirmed or maybe not confirmed with this upcoming round of earnings reports.
Steve Grundman: The only thing I would add to that, Jen is all of these federal contractors and I'm not sure how far the mandate for vaccination flows down or up, let's call it, upstream into the supply chain, but that should have a salutary effect on allowing these companies to operate with less disruption from the virus than they otherwise would if they didn't have, by some accounts.
Steve Grundman: I think Byron 90, 98% employees who are vaccinated. I don't doubt that in large companies, even a percent or two of their employees who will end up getting dismissed for refusing the vaccine can be disruptive. Yep. That could happen. But I don't think it'll be anywhere nearly as disruptive as the actual incidents of COVID through of the workforce was in 2020. And I think in the late fall of 2021.
Jen Dimascio: Thanks Steve, in the general press you have heard during COVID a lot of news about the supply chain and problems with the supply chain, how is defense in particular being affected right now, defense supply chain, where are some of the pain points?
Byron Callan: Well, I have to believe that the same factors that are impacting and the rest of the general economy, the delays you're seeing in shipping semiconductor spot shortages, basic raw materials, getting shipments in time for really an entire sector, not just aerospace and defense, but the rest of the economy that really got used to working with lean inventories.
Byron Callan: I don't think, as much as there may be focus, Jen, on inflation and the CPI number that came out recently that showed the United States was on a 7% annualized growth inflation. If you break that down and look at the components of that CPI, a lot of it really didn't have that much to do with defense. The biggest components were things like used car prices and apparel.
Byron Callan: So, it's not to say that Americans are not seeing that in their day to day basis. But if you think about the costs that contractors may have baked into some of their bids. I mean, for the first part, most of these companies, the large ones in particular have long term supply agreements where they may be somewhat insulated from month to month changes in inflation. But then the second thing I just want to draw is I don't think that the inflation, the CPI number, that's not necessarily getting telegraphed back the types of cost increases that the contractors would be seeing.
Byron Callan: The only other thing that I'll add, because I know this came up during the January 12th hearing on the impacts of a continued resolution, the DOD Comptroller had talked about higher fuel prices and a need... That was another billion or two above what DOD had been planning this year. So that is something there are multiple perspectives on inflation and how it's going to affect things, but higher fuel crisis is something that's going to affect DOD spending.
Steve Grundman: Yeah, I will add to that, that whereas in the commercial economy, I think a lot of the supply chain disruption has involved imports. Bringing chips in from Taiwan are peace parts from China and elsewhere in the commercial economy that's been disrupted by the COVID crisis. And then frankly, the knock-on effect in terms of capacity that the original incidents back in 2020 of the COVID crisis imposed.
Steve Grundman: Our defense, the US defense industrial base is hardly insulated from international trade. And indeed it's been a strategy of the Pentagon to better integrate. Particularly, its close allies industrial bases with those of the United States over the past 20 years. Having said that certainly by comparison to commercial markets and all other things being equal, it remains the US defense industrial base. …
Steve Grundman: Mostly, there are important exceptions of course, but we mostly have supply chain that is indigenous to, and self-contained within the United States. And again, there are some disruptions just think about how long it takes to get them mail these days. It's not that there aren't disruptions even inside the United States, but they aren't the big disruptions that have, for example, made me wait three months to buy a Hyundai last summer. Those aren't or the source of them are not in great evidence in the defense industrial base.
Jen Dimascio: Interesting. Defense was a bit of a safe harbor for the aerospace contractors that might have been impacted by a slow down in the commercial aviation market. What happens as the commercial sector begins to rebound in the future?
Byron Callan: I think Jen, boy... Let me start over with that thought. It's a good question. You could start to see some pitches in supply chains, again, as you airline activity ramps up again and maybe build rates start to climb. I think there's some time to think about it. I'll say this just because I think it's very topical. I think an interesting issue could be what kind of incremental defense demands emerge depending what happens with Russian and Ukraine in coming months.
Byron Callan: Is there a push to try and flow some of the equipment that's been ordered by European states like Poland, Romania, Finland, Sweden, as a result of a sharp change in the European security environment. So to me I'm more mindful of that than really what happens with commercial aerospace and how that might impact defense suppliers and defense's ability to manage what really was going to be a slow growth period in 2022 and 2023.
Steve Grundman: Yeah. I see the recovery of the commercial aerospace sector. We're talking, manufacturing and services now, not the airlines per se, as net positive for defense in as much as cash flow in companies quickly, those that are diversified between commercial arrow and defense should on the aggregate improve and so that all of the things being equal should make being in the defense business a little bit easier, right?
Steve Grundman: If your defense business needs some CapEx and you're in a defense on a diversified company that that's been a harder decision over the last two years. And I think it will be in the succeeding year and hopefully beyond as the commercial side of those businesses improve, they will have more aggregate cash flow to allocate between their two businesses. The answer to the question ...
Steve Grundman: Depends a little bit on how each of those companies has managed the contraction in its commercial aerospace business, the degree to which they have reduced capacity, which in this industry these days means as much people as it does capital equipment and floor space. Certainly companies that may significantly decreased their capacity by comparison to the steady state level, let's say the 2019 level of capacity I'll call the term generally, that could be potentially disruptive.
Steve Grundman: You could, I'm speculating unfortunately, though, when I say, yeah, you could find a situation where a company's got to decide whether it's going to allocate his engineers to the customization for a new commercial order or to pull and so doing, pull them off of a defense product that's possible, but I'm hypothesizing that I think the more general effect is positive because there'll be more cash around.
Jen Dimascio: Interesting. So I wanted to touch on one thing that was big at the outset of the pandemic, the Pentagon really moved to allow a greater portion of contract funding to be paid up front. The releasing a greater percentage of progress payments to contractors on defense contractors. Do you think the Pentagon is like to continue in the change that it made to allow liquidity to flow to contractors? What's the fate of that likely to be Byron?
Byron Callan: I think, you really have to go back in time. I mean, yeah. DOD in 2020 stepped up progress payment rates with the under to the primes, with the understanding that would be flowed down to their subcontractors. So, it may be a two step process here, which is well first as we do start to normalize and I mean, arguably that's debatable, but I think when we're back to a steadier state for commercial aerospace, then do DOD could revert to the progress payment rates that existed when the, prior to the onset of the pandemic.
Byron Callan: But then I think there's still a bit of unfinished business, which really goes back to national defense authorization act stipulation that DOD really had to look at these contractor financing, progress payments, and come up with some alternatives that may be aligned the progress payment rates with incentives to perform well.
Byron Callan: And I think as you're aware, there was a false start on that. That was quickly beaten back if memories of me that was in the fall of 2018, but I'd have to go back and look at that. The point is that's still a little bit of unfinished business and I think it is something that maybe back on the table this year, or certainly next, which is, should DOD continue with the progress payment schedules that exist particularly given the very low cost of borrowing money right now. And frankly, the very strong financial position that most of these large public companies find themselves in.
Steve Grundman: Hey, Jen, I'll tag onto that. It's not directly on progress payments, but let me continue. The thread pulling the thread on cash flow Byron mentioned in an answer to one of your previous questions, the looming problems arising from the 2022 federal budget being on a continuing resolution even now, but certainly if it persists for companies that are performing on programs that were programmed in '22, to get bigger, to grow, to spend more and unless the Congress creates a carve out in its continuing resolution for that program, then it's going to be stuck at the 2021 total level of spending.
Steve Grundman: And somewhere if we end up, this is certainly one of the issues about the anxiety you hear both from the Pentagon and from the aerospace trade aerospace and defense trade associations about a full year CR that is to say a continuing resolution that lasted not just to February 18th or whenever the current one expires, but all the way through the end of the fiscal year, so that we never have a full year appropriation.
Steve Grundman: One of the impacts of that will start being felt in defense companies and in their cash flows. And frankly in the capacity people and otherwise that they're able to maintain is an industry for programs that would've grown in 2022, but for which there won't be legal authority of the government to obligate the funds that would otherwise in a normal order as it's put appropriations bill would've flowed to them.
Steve Grundman: So, I wouldn't worry so much about progress payment rules affecting cash flow this year. But this continuing resolution, again, it's not for every program that's it's going to bear on. But for those that we expecting they're performing on a program that was supposed to get bigger in '22 than it was in 2021. There won't be the legal authority for the government to obligate more money to them.
Jen Dimascio: That's an important perspective. And we've been through so many iterations of continuing resolutions. It's a perennial issue now and one that gets worse in an election year as we're coming up on. I did want to touch on something that you wrote in your column, Steve, which is that you're really seeing some signs of strength within defense. Can you elaborate on what those are?
Steve Grundman: Sure. And thanks for asking, I appreciate Aviation Week publishing. I think it's in the print edition this week, an essay I've written on the health of the defense industrial base. I was motivated to write it by what felt like a clamor of hand ringing to deliberately mix a metaphor. A clamor of hand ringing about the health of the defense industrial base.
Steve Grundman: And this is a topic which has been in at least the specialized news, maybe not the front page of the paper, but specialized news dating all the way back to the beginning of the Trump administration, which you may recall initiated under what I think was called executive order 13806, an assessment of the defense industrial base.
Steve Grundman: I mean, it's always a topic that comes and goes, but the steady drumbeat of attention and worry about it. I date back to 2017 and then it was ultimately, I think, published in 2018, this assessment, but then since then the trade associations, including most, especially the national defense industrial association publishes an annual assessment of the health of the defense industrial base, theirs is called vital signs.
Steve Grundman: Their most current as such assessment is due out later this month. And even the government itself every January, although it has not yet been published this year, the office of, the office I used to run, the office of the deputy assistant secretary. It's now called for industrial policy, sends a report to Congress on the industrial capabilities forward. And certainly last year's report, the report that former undersecretary Ellen Lord signed out just before leaving office.
Steve Grundman: Was a one which in the overall had a worried tone about the health of the defense industrial base. So, there's this clamor of hand ringing about the defense industrial base, which when I step back from it, I used of course, the tired metaphor of trees and forest. I don't deny there are some sickly trees and there are some diseased quarters of the forest, but it's hard to step back and look at the whole forest of the defense industrial base and not regard it as basically healthy.
Steve Grundman: I'm not ready to give it an A plus or anything like that. But when you look at, and I put a few citations down on the attributes of health that are most important to me. When you look at some measures of the attractiveness to talented people, particularly engineers of the defense industry.
Steve Grundman: When you look at the capital of appreciation, the difficulty or ease with which this industry can attract capital and make its cost of capital by implication. And then the third attribute that I looked at already escaped my own mind there is technology. When you look at the capacity or propensity of this industry to apply advanced technology to the to solving its customer's problems, I'm pretty comfortable by those terms, right, by those dimensions of talent, capital, and technology, I'm pretty comfortable with the health of the defense industrial base.
Steve Grundman: Again, I don't think it's ready to run a marathon. It's not an A plus to mix more metaphors, but I certainly don't think it is an industry in decline, which I think anyone coming from outside our industry who might read this succession of assessments would think, boy, that's an industry in decline.
Steve Grundman: By my observation it's not that case, but which again does not mean we haven't got some trees and even categories of trees that need attention or I think I did use a little bit of horticulture metaphor to say, "Yeah, we need to do some greening of our habitat. No doubt about it, but it's not a reclamation project. It's just normal greening and gardening of our habitat in my view."
Jen Dimascio: Thanks Steve. Byron, did you have anything to add to that?
Byron Callan: Look, I generally agree with what Steve has said. I think, have you looked at just add, have some more perspective on this. Okay. The defense stocks they've underperformed in 2021. I think they also underperformed a bit in 2020, but there was a lot going on from a relative standpoint, the market was really playing these recovery place on the expectation that the pandemic was going to wind down.
Byron Callan: And there was a reset in sales expectations, but I don't think that really had anything to do with that was what cell side analysts were projecting versus what some of these underlying growth expectations were that I think were probably in strategic plans all along. I mean, you could line up DOD investment outlay projections and see there was a pretty wide gap between what sell side sales expectations were for large defense contractors and what those investment outlays might, might suggest operating margins have been healthy.
Byron Callan: That has been, I think, really something that attests to the strength of the business to manage costs through a period when they were getting bombarded with a lot of changes from the pandemic and from a supply chain and cash flow has been pretty good. DOD to the point earlier, Jen, had stepped at progress payment rates, but you didn't see companies going out and borrowing massive amounts of money.
Byron Callan: I mean, on the contrary, they really started to step up their share repurchases, really to I won't say historic highs but a very big increase in share buybacks, including using cash from divestitures to buy back their stock. And that's not something that you would see from a sector that's in distress. Now, I have to preface all that and say, my view is shaped by the large publicly traded companies, some of the smaller and midsize ones too.
Byron Callan: I don't deny it all that there may be some real stress among the so-called third and fourth tier contractors that also got. Caught up with real collapse in commercial aerospace demand. So there might be some pressure points there, but I think and I'll say two other things, Steve may have alluded to this in his article, but if you're looking at metrics like, the decline in the number of subcontractors or the decline in floor space that had been allocated to defense or defense and aerospace by the major contractors, in some ways, those can be viewed as signs of efficiency, not of trauma, you're seeing consolidation among the supply base.
Byron Callan: That's been a natural vector. You can look at the M&A data to suggest that, and then when you get a merger, like the Raytheon-United Technologies deal, of course, you're going to be reducing for floor space. They're in effect trying to squeeze out some of the cost synergies from that merger. So I don't necessarily see that as a sign of, is befalling the defense sector?
Steve Grundman: Well, I just wanted to tag on, because I do think it's important. I'm struck by Byron's point, because it's so true of me equally that, my observations about the health, particularly the issue about capital are drawn off of the large cap stocks by and large, or even, even for that matter, the small cap stocks just simply the publicly com companies with publicly traded equity. And I have no doubt that there'll be someone listening to this podcast in a small and medium size enter prize for whom the world really feels completely different. It's hard to hire.
Steve Grundman: It's hard to borrow money if they want to borrow money and, and they don't have the tools with which to integrate AI or other advanced 21st century technologies. I want to acknowledge that the world probably is harder for the small and medium size enterprises than it is for the larger companies that from which I'm drawing most of these observations on the one hand, on the other hand, it always is generally speaking, harder, upstream, far upstream.
Steve Grundman: Those are harder businesses, particularly... I'm sorry, they're not always harder, but they are harder in a period of change. Sometimes being upstream is the great place to be when you're in a super stable business because you don't have certain reserves and other things that the big companies have to keep on hand for public fiduciary servicing their fiduciary obligations. But in a context of change, and this is that. And I don't just mean defense budget or even particularly defense budget. I do mean more technology, customer taste preferences competition.
Steve Grundman: In a world of change. It is always harder to be upstream as a small and medium size enterprise than downstream. My point being, I want to acknowledge that there probably is some suffering out there that I'm not that my sentiment surely does not adequately reflect, but on the other you'll have this in a world of turbulence, regrettably, but I don't think that all adds up to a sick defense industrial base, if anything-
Jen Dimascio: Yeah. And I think I-
Steve Grundman: It puts a bigger onus on the prime contractors whom the department of defense is relying on to manage their supply chains, to do some gardening of their own. If I may grab that metaphor back to do some gardening of their own supply chains and not imply as often, it seems implied that this is the end user, the government customer's obligation to maintain a green habitat in, in, in the supply chain of the defense industrial base.
Jen Dimascio: Yeah. I think I was struck by your column and in its reference to new technologies and new ways of operating in aerospace and defense that is automotive companies joining in and new entrants like Andruil and companies that are maybe reshaping what the defense industrial base looks like.
Steve Grundman: Yeah, that is an important part of the disruption. So I appreciate you growing that to attention because it really frames the point I'm trying to make. So those entrants are potentially anyway and I think manifestly in the case of Amazon disruptive, but from the 35,000 or even 15,000 point of view, looking at the forest entry is a Cardinal sign of good health. If this is an industry that is attracting big companies, small companies, new companies, old companies, and for particularly companies that want to leverage advanced technology, that's a pretty Cardinal indicator of health in my view.
Steve Grundman: And so as I said in the article, the cacophony of indicators, otherwise notwithstanding, I am very heartened about the health of the defense industry by the amount of entry from companies like those you've mentioned that we can see, and they're not the only ones. It's quite an interesting thing. The degree of entry we see into this industry right now.
Jen Dimascio: Well, unfortunately that's all the time we have today, but I really want to thank you all for listening to another edition of Check Six, which is available for download on Apple Podcasts for Google Podcast, Stitcher and Spotify. See you next week.
Steve Grundman: Thanks Jen.
Byron Callan: Thanks Jen.
Steve Grundman: Yeah. Thank you, Steve. Thanks Byron. Thanks Donna.