Seven Forces That Could Reshape Defense

Current U.S. policy was set forth in 2011 by then-Under Secretary of Defense for Acquisition, Technology and Logistics Ash Carter when he stated that the Defense Department would block mergers among its five or six largest contractors. Though unlikely, the next administration may conceivably bring new attitudes regarding the size and scale of large defense contractors. A new wave of consolidation among the largest companies could be the most significant change in structure. Divestitures could be triggered by mega-deals, too.

While startups have not yet triggered a defense sector restructuring, that could change by 2017-19. The military space sector may be the most vulnerable to change if SpaceX can conclusively demonstrate the economics of a reusable booster. Smaller satellite networks and other launch concepts could create further pressure on heritage defense space operations. If the Pentagon can lower barriers to entry in defense and encourage more new entrants, this could compel heritage companies to choose where they can and cannot compete. Private technology companies may bring very different business models and financial objectives than public ones, and this is another feature that could shape industry structure.

Although currency exchange rates are probably not top of mind as a factor shaping defense, in the mid-2000s BAE Systems purchased Armor Holdings and United Defense, and Cobham, Qinetiq and Serco also acquired U.S. operations. At that time, the exchange rate of the U.S. dollar to the British pound was approximately $1.80-2.00—much higher than the current rate of $1.24. If the U.S. dollar strengthens further against the pound or euro, it could make some European defense operations relative bargains, and this could be a factor in spurring another round of transatlantic consolidation. Defense in the U.S. is mainly an export business that builds products in America. If currency exchange rates diverge further, it may make sense for management and boards to consider more transnational footprints to remain globally competitive.

Analysts and investors have bid up defense valuations in the belief that a new defense spending upturn is starting. They are generally more negative on commercial aerospace because of book-to-bill trends and product transitions and softness in business jets. Activist investors could seek to exploit these valuation differences, particularly in companies whose portfolio straddles both commercial aerospace and defense by pushing to unlock the value of defense operations accorded a commercial aerospace valuation.

These will also bear on where value can be created in defense. Companies may lose sustainment of proprietary systems on platforms and see reduced scope of software work. However, value should be created for companies that can rapidly develop and field new subsystems, though that may take more research and development.

Since the 1970s and ’80s or earlier, very few new entrants in defense have grown to several hundreds of millions of dollars in scale. Most such companies were snapped up in the 1990s and 2000s. Growth by acquisition of defense product companies may be a more difficult strategy to execute. There were divestitures of product-focused defense businesses in the 2000s that were not seen as good fits in defense conglomerates, but that trend may accelerate in the coming years, particularly if operations are not contributing to growth.

Directed-energy and rail-gun systems could change prospects for energetics suppliers and companies providing kinetic weapons that might be displaced. Additive manufacturing may change the economics of spare parts, and autonomous systems could influence needs for support, sustainment and training. 

The defense sector of 2021 or 2026 will look decidedly different than the one of today.