Podcast: A Decade of Disruption is Headed at Defense Companies
The consensus from the Aviation Week DefenseChain Conference was that defense primes and suppliers are about to see their world turned on their heads. Executive Editor Jen DiMascio talks with Business Editor Michael Bruno and Capital Alpha Partners Managing Director Byron Callan about the challenges ahead.
Here is a rush transcript of the October 22nd podcast.
Jen Dimascio: Hi and welcome to the Check Six Podcast. I'm Jen Dimascio, the executive editor for Defense and Space. And I'm here with business editor, Michael Bruno, and a special guest, Byron Callan, of Capital Alpha Partners.
Jen Dimascio: We're here to talk about a few things. We're here actually at the DefenseChain Program Excellence Conference in Tysons Corner, Virginia at the swanky Ritz Carlton Hotel. And anyway, I just wanted to talk a little bit about a lot of the panels and themes that we heard yesterday. Michael, what were some of the takeaways?
Michael Bruno: Yeah. First of all, great to see everybody, Byron, great to see you be back in person. Not only are we back in person, we're back in person in style at the Ritz Carlton, so that's the way to do it. Yeah, so coming off of the first day of the Aviation Week DefenseChain Conference. I took some notes. Nothing is for attribution, because it's all Chatham House rules, but I can talk about the themes that people talked about and what we heard, and particularly what was surprising.
Michael Bruno: And so here's my nutshell of day one. It started off with an amazing panel that included Byron Callan, I think I'm free to say that part because it's public knowledge. And I was just amazed about the fact that we all thought we were entering a decade of disruption. This is a decade of disruption for the defense industrial base, big and small, prime and supplier. Just across the board it's going to mean change for numerous reasons.
Michael Bruno: One of the biggest reasons there's going to be change is there's this sense that the network is eating the national defense strategy. And connectivity is going to be increasingly just so much, not only a part of what the platforms are expected to do, but what the actual defense strategy, what the operational plans are expected to do. And that of course means what the industry is going to have to feed into.
Michael Bruno: I made a joke to some conference goers that if you remember President Clinton's campaign speech from the nineties, "It's the economy, stupid." Well, now it is not the platform, stupid. And if you think about that for a moment, that's a huge, huge change for the defense industry, because the entire business models of all of our primes and the suppliers are based upon selling a product to the government and getting the profit margins out of that. So quite a bit of change that's coming.
Michael Bruno: Obviously this is a defense supply-chain-oriented conference, so a whole lot of talk about the trends we're seeing in the supply chain. And I would say chief among them, not only concerns about the supply chain, but concerns that suppliers have themselves, chief among them is cyber security. This gets harped on from everybody from the White House on down to, well, everybody in the industry. It's a concern of procurement officers in the Pentagon. It's a concern of the Secretary of Defense. It's a concern of the President.
Michael Bruno: The fact that the supply chain is now probably getting targeted, not probably, we know it's getting targeted as bad and quite possibly even worse than the prime OEM level. But the prime and OEMs have had a chance to respond. I mean, they learn the hard way and there have been breaches there, but the suppliers are now getting caught basically with really old technology that may not have been updated. And so that's a big, big concern now, cybersecurity for everybody.
Michael Bruno: Obviously some concerns about workforce and having enough employees. This is a big trend that's hitting the entire US economy, in fact, the Western economy. But it's a little different inside the defense industrial base. It's not just simply that some people are choosing to leave and follow new paths and maybe go live in the mountains and do something else. Actually, what the concern is, is about having enough workers to scale up so that when the day comes that they need to build more of something, will they actually have the workers there to do it? Yes, there's a lot of automated technologies coming online, but it is not seen as enough to just completely replace workforces.
Michael Bruno: Meanwhile, there are near term concerns about things like inflation and other cost pressures. This gets at the fact that the biggest concern for the suppliers right now is about protecting the profit margins of their own companies. They need to make money. And so if you've got raw materials increasing, if you've got workforce costs increasing, this is going to be difficult.
Michael Bruno: And finally, there's just demand for more speed and more risk within the supply chain for everybody to adopt there. Competition's going to increase, a lot of these factors I've just talked about are expected to weigh on the supplier base. It just sets us up for a decade of disruption.
Jen Dimascio: Yeah, that sets us up for a decade of disruption. It was a fantastic summary of about eight hours of content into just a couple of minutes.
Jen Dimascio: Byron, I wanted to ask you, you wrote a column for us recently, and it's geared toward what companies should be thinking about heading into the end of the year and a new year in 2023. Can you talk about some of those themes?
Byron Callan: Yeah. And thanks for having me today and at the conference yesterday. And it's a very good conference by the way, because I think you really do get to some of these issues that don't always get aired and it's an important gathering, I think.
Byron Callan: Workforce reaction to vaccine mandates. And I think that's going to be an interesting issue for the sector to walk through literally in the fourth quarter and into 2022. Because if you look at states with low vaccination rates, there are large concentrations of defense contract workforce in some of those states, Florida, Texas, the Southeast Alabama, around Huntsville.
Byron Callan: And I think it's just going to be interesting. There was a comment yesterday about the numbers in some workforces that could be at risk of leaving. Obviously, they're not going to go to another defense contractor, but they may find other areas of work that still need their engineering or trade skills. And that potentially could be a disruption. And since we're on the eve of another earning season it's going to be interesting to hear what management say about that. Do they couch or parse some of their guidance for that particular risk? Because it's something, it's not just their own companies, but it's going to trickle all the way down in their second, third and fourth tier suppliers.
Byron Callan: The budget obviously is in their perennial, I suppose, uncertainty particular at this time of year. Senate appropriations mark just came out this week for their look at the FY 22 budget. And they added 24 billion to the DoD budget that they mark, the Veterans and MilCon Committee does another mark for that part of the bill.
Byron Callan: But you still have this standoff, I think, where there appears to be bipartisan support for a defense spending increase, but it's just not clear if that's going to survive if you don't get other parts of the Biden administration ... Even though it may be scaled down, if you get some of that through. We've got a [continuing resolution (CR)] through December 3rd, I think industry is going to be looking at another period of uncertainty with potentially lengthy CRs extending into 2022. And that's just something else you're going to have to deal with and grapple with.
Byron Callan: The market, I think, has been habituated, managers have been habituated to the idea that you usually start the new year, this was one of the panelists who discussed this as well yesterday during the conference. It's not unusual at all for the government fiscal year to start with a CR and I think the sector's gotten used to that. But it's lengthier ones that you work out because I think that's where you start to get these cascading cautions, what programs have there been anomalies for that you can actually increase rate or have new starts. What's still left on the table that you can't do, things. It's an interesting time.
Byron Callan: And to the disruption part, the decade of disruption. Absolutely. I mean, I think the important part is, it's maybe morphed a little bit from big company versus little company, Silicon Valley versus the incumbents in the defense sector. Because there are some large, well-established contractors that are disruptive in their own right. And there's some new entrants like GM Defense, for example.
Byron Callan: One of the other themes that's been discussed at this conference, and Michael just mentioned this idea about the decade of disruption and that contractors, all contractors, are really going to be looking at a different competitive environment that's really been driven by the pace of change in technology. The issues with supply change, we're not in a globally integrated supply chain anymore, so how does that play through back in the costs and where your sources of supply are.
Byron Callan: But I think this question of technology ingestion, who are some of the new entrants. There have been a lot of attention about Silicon Valley startups, but I'm personally intrigued when I see people like General Motors Defense or Jacobs Engineering, KBR, companies that you don't necessarily think of as defense contractors, are looking to penetrate defense markets.
Byron Callan: For the large established primes, they are going to have to be agile. I think one of the spokesman from one of those people use that theme, that there's going to be a lot more agility and ability to respond quickly to some of these changes. And I think probably the worst strategy is just sit back and watch the clouds go by, it's not going to be that sort of environment. For some of the sectors might have existed where you had a slow, steady business last decade, I think it's going to be very volatile this decade.
Michael Bruno: I want to pull in that thread a little bit if I can, because, Byron, you have written quite a bit about this. And for those in the audience, Byron Callan is a little bit of a dean of Washington analysts when it comes to the defense sector. A lot of people read your reports that you put out and cite them.
Michael Bruno: And you have been writing for years about the challenge that at the prime OEMs have at their level, of repositioning and differentiating themselves. Particularly, how are they going to differentiate from each other and how are they going to grow above each other? What makes a difference between one or another?
Byron Callan: Well, I think, and this is a good point, because one of the other panelists on The Four Horsemen Panel yesterday made the point, and I absolutely agree with this. That you typically see new entrants in defense markets when there's a new technology, and that person couched this in the historic waves. Ship builders didn't go out and invent airplanes, they suddenly saw an influx of Lockheed, Curtiss-Wright, Boeing, on down the line. Defense electronics was really Loral, Sanders, E-Systems, GTE, Texas Instruments, a whole new range of competitors emerged.
Byron Callan: And I think back to your point, Michael, about if this is really the decade of a network, and the network is going to be the holy grail the department is looking for. There are going to be new entrants there, you see them already. And everybody from Amazon and Microsoft, down to Andruil and probably 30 or 40 other small companies that are also looking-
Michael Bruno: 500 little pop shops around the D.C. Area alone maybe.
Byron Callan: Yeah, yeah. And when you hear things, like the Army Project Convergence has something like 70 ... I know I'm not going to get the exact number right, but it's something in the 70 to 75 range of the number of industry partners on this. I think most contractors will say that JADC2, Joint All-Domain Command Control, push the department is making is a business opportunity for them. But who's really the clear leader in this? There are bits and pieces that companies may plug into.
Byron Callan: But back to the point that you just raised, Michael. I don't think the market has really figured out ... The market, investors haven't really figured out who's the anointed leader in this. And is it really going to be big enough to materially change the growth expectations for any one contractor? The large publicly traded ones.
Jen DiMascio: Well, last week the CEO of Lockheed Martin gave a speech, and it was all about the network.
Byron Callan: Yeah.
Jen DiMascio: And so there I think you see a big prime trying to adapt to the new situation, but there's not firm guidance yet coming out of DoD to say one way or the other, to choose a winner here yet.
Byron Callan: Yeah. And again, one of the things that I thought was interesting yesterday, again because the conference's Chatham House rules, but there was a speaker who said you really don't have the leadership yet in DoD to push this thing and get the three services all pointed in the same direction. He raised, if I recall, two or three options where this could play out. That maybe you need an equivalent of a Missile Defense Agency, for example, too. Is there a JADC2 agency that's really-
Michael Bruno: A combatant command, an idea.
Byron Callan: Exactly. But you have to have some kind of ... You can't just have the three services running in relative close coordination with one another. And I frankly think there may be a budgetary aspect to this too. I've yet to see the JADC2 line item in the Department of Defense budget. I'm aware of some of the companies that really mine the budget documents and can pull all these separate strands together.
Byron Callan: But the market right now I think is also having a little bit of difficulty as to understanding how big a market is JADC2, what exactly does it mean, and who's going to really provide the building blocks for that? Is it all software? It's got to be processors, it's got to be radios, antennas. I mean, everything you think of when you talk about moving data around at the speed and the security that DoD wants to move data.
Michael Bruno: And I just want to follow up, Jen, you were talking about Jim Taiclet, CEO of Lockheed, giving the speech last week and talking more about his, what we'll call the 5G.MIL idea and how he wants to make Lockheed at the forefront of that. And that's wonderful. I wrote a column a little bit in praise of Lockheed and Taiclet trying to make that change.
Michael Bruno: The big, big problem for Lockheed and Taiclet is that the stock market, right, Byron, is just, they're not only not buying it, they're confused right now. Because if you are an investor in Lockheed, you invest in them because they build the F-35 and they have a very nice profit margin there, it's about 27% of their annual revenue. And you get what you want when you invest in Lockheed. You're not thinking that they're a tech company, you're thinking they're a platform provider for the Pentagon and they're the biggest one at it. And that's what you want them to keep doing.
Michael Bruno: So it's a huge mindset change, and not just within the defense industry. Byron, this better than anybody, you worked on Wall Street. We've been here before 20 years ago with transformational technologies and I don't think anybody bought it then either.
Byron Callan: Well, no. And I think, again, we're on the eve of another earning season. One of the things I do as you go through these earnings calls and count questions, and the number of questions that are asked. And typically, I know with Northrop Grumman, because they're another company that is doing some interesting things in JADC2, more broadly, army networks for example. But inevitably, I think, in every one of their calls in the last six quarters, everybody asked about Ground Based Strategic Deterrent, and then their program questions about F-35. I don't recall much about JADC2 and how are they positioned.
Byron Callan: And some of these workforce issues that have been discussed here, supply chain issues, there were questions in the first quarter of 2020, but it was really COVID related and how's your workforce doing, but it's not part of the questions that cell-site analysts are posing to managements yet. And at the same time, I don't think managements have really been good at articulating, "Here's a billion-dollar market that's going to grow at 10% a year for the next five years. And we're going to grow fast that because of these 18 capabilities that we have that are unique."
Byron Callan: I think that's difficult to articulate right now. And when you get to a company like Lockheed Martin, to your point, Michael, JADC2 is not going to be the size of F-35. Or people are going to focus on F-16 and F-35 and C-130Js, and that's for better or for worse the nature of the beast. As much as I think their chairman, president and CEO did make what I thought was a very interesting set of comments and observations about where they wanted to take this thing, how they were going to partner with commercial technology companies to bring these technologies to address defense needs. And it was a differentiated strategy that hopefully they spend more time explaining their shareholders and analysts.
Jen Dimascio: Well, unfortunately, that's about all the time we have today. We're going to have to wrap it there. But join us again next week for another edition of Check Six, which you can download on iTunes, Google Play and Stitcher. Thanks for listening. Bye.