Defense Industrialist

For all but Raytheon, a whole new realm of conflict seems disinteresting to industry.

Going on eight years now, Raytheon has been mounting a strategic campaign in cyber security. This past April, the company spent $1.7 billion on Austin-based Websense, the 13th cyber business it has purchased since October 2007 (Defense Mergers & Acquisitions Daily, 20 April 2015). In Forbes, defense industry booster Loren Thompson called the transaction “bold”—the value roughly matched that of the 12 preceding deals. That pattern suggests that Raytheon has been learning along the way how to build a successful business. More recent evidence was Raytheon’s selection this month as a finalist in DARPA’s Cyber Grand Challenge, in which some of the top teams in the US have been working to create self-healing code. As Byron Callan of Capital Alpha Partners wrote, that alone “suggests it's doing something right,” whatever misgivings investors and their analysts may have had about Raytheon's long-running strategy.

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The USMC has always had a backup plan. It’s called 'Super Hornet'.

The US Marine Corps is definitely putting a brave, can-do face on its first unit—Squadron 121—of Joint Strike Fighters (JSFs), aiming shortly for a formal declaration of “initial operating capability.” But Michael Gilmore, the Pentagon’s chief weapons tester, recently penned a dimmer account for procurement chief Frank Kendall. In recent tests on the helicopter carrier Wasp, he wrote, "aircraft reliability was poor enough that it was difficult for the Marines to keep more than two or three of the six embarked jets in a flyable status on any given day.” The Marines have spent billions on the F-35B and the F-35C. Had they not, they might have spent many fewer on the F-18F, and so far, without a noticeable difference.

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The US Navy could have spent mad money on drones.

This month, the US Marine Corps declared that its first squadron of F-35Bs had reached “initial operating capability”. That’s 21 years after the program first began as the Joint Advanced Strike Technology (JAST) program, 18 years after the first Joint Strike Fighter (JSF) design contracts were awarded, and yet 13 years after Lockheed Martin won the development contract for the F-35 Lightning II, way back in October 2001. It’s notable that a war started the month prior to that award. Perhaps it’s intriguing to ask what might have happened if that contract had never been signed—if, perhaps, the Pentagon had gone all-in supporting the fighting in Afghanistan (and later Iraq), and found some other solution for backfilling its aging fighter fleets.

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Recovery from battlefield surprise requires more than fingers-crossed strategy.

Last month, the Pentagon released the 2015 version of its National Military Strategy. As a real Pentagon strategist  reminded me, the Pentagon doesn’t really post its real strategy on the Web as a PDF. But even this public relations exercise was disconcerting in its telegraphed inflexibility. The document waxes on about deterring, denying, disrupting, degrading, and maybe even defeating adversaries, as if these were deterministic events. For wars don't always go according to plan, and as the Economist noted in its review of Lawrence Freedman’s Strategy: A History (Oxford University Press, 2013), “a strategy is not a plan.” Or as Gerard de Groot wrote in his review of the same, the boxer Mike Tyson may have put it best: “everyone has a plan until they get punched in the mouth.”

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North Americans are really uneconomical shipbuilders, and their navies should demand better.

Ford announced this week that the company will stop building small cars in Michigan, or anywhere in the States, as price pressure precludes paying workers what’s worth their while. Ford will build its new Lincoln Continental in Michigan, but that’s because the profit margins on luxury sedans can support the prevailing wages. As those twin reports in the Wall Street Journal reminded us, not all companies in North America are equally adept in all tasks, so not everything should be built in the US and Canada. That’s just Ricardian comparative advantage. So why are North American military forces trying to buy everything there? The cost penalties are particularly dire in shipbuilding, but they could be otherwise, with a really serious effort at innovation.

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Pushing for innovation against existing challenges is unlikely to yield dramatic change.

We need innovation! We need to look to non-traditional defense suppliers! How often have we heard that refrain? I did again in April, when US Defense Secretary Ashton Carter insisted in Palo Alto that “we need the creativity and innovation that comes from start-ups and small businesses.” However, the record of bringing innovation into defense is mixed, and seems little changed over the years despite such statements. The Defense Department is asking for innovation, but innovation to solve its existing challenges. That is perfectly understandable, but fails to understand how innovation actually occurs—especially outside the traditional defense arena. For three reasons, pushing for innovation against known problems is unlikely to yield dramatic change.

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A Bell-Sikorsky combination could be too big for the Pentagon to handle.

Bidding for Sikorsky, Reuters reports, rests now with Lockheed Martin and Textron. As noted here a few weeks ago, the tax implications remain daunting for United Technologies, particularly now that Textron’s proposed Reverse Morris Trust has elicited no interest. Spinoff does remain in the running as the high-value option for shareholders. Regardless of what benefits the owners, though, procurement strategists should care about who those owners are. Selling Sikorsky to Textron would create a firm that dominated supply of rotorcraft to the US military, with potentially adverse implications for the conduct of its own buyers.

As I wrote earlier, an independent Sikorsky on the NYSE would change little for the buyer. The new company would need to pay for some new corporate functions from its existing sales forecast. Profitability might suffer, as Sikorsky’s low margins are what led UT to seek an exit. That said, the firm would be a Fortune 500 in its own right, so the costs would be manageable. Moreover, the US Government has shown that it cares more about solvency than profitability, and doesn’t allow its suppliers the margins that would make profit-fueled independent R&D really valuable. A separate Sikorsky should concern almost no one politically.

A Lockheed Martin Helicopters, however, solves some long-standing problems for Lockheed, and maybe for customers too. As Byron Callan of Capital Alpha noted, Lockheed’s interest “is not surprising, given its long-standing work on Sikorsky platforms, including the SH-60 program… and the Combat Rescue Helicopter.” I hate to say it again, but we should also recall two unfortunate aircraft programs which Lockheed screwed up as prime contractor. Its presidential transport effort with Agusta and its Airborne Common Sensor with Embraer failed in large part because the company’s electronics people wouldn’t or couldn't leverage the experience of its aircraft people. (The Wall Street Journal’s 2006 story about the ACS is illuminating.) With Sikorsky inside, Lockheed next time would have an actual helicopter company to keep it in line.

On the other hand, as Reuters did observe, Lockheed’s efforts to work with other aircraft companies have indeed shown that vertical restraint shouldn’t be feared in this case. That’s the technical term for the refusal by a supplier of a crucial input to work with a competitor, even when that’s what best for the ultimate customer. Chances are, Lockheed would work with all comers, make its money, and keep that main customer happy.

A Bell-Sikorsky combination would indeed create the largest rotorcraft company worldwide. With $10.8 billion in pro forma 2014 sales, Textron’s combined rotorcraft activities would be almost a third larger than those of today's Airbus. The two product lines overlap only slightly, and that’s generally viewed favorably in antitrust considerations. The problem is that a Bell-Sikorsky would also consolidate most of the US military’s supply of rotorcraft in a single firm. The Pentagon will still buy its Chinooks, and half of each Osprey, from Boeing, but those are declining lines.

The Future Vertical Lift program lies a ways in the future, but a Bell-Sikorsky would have most of the work on the two funded entrants in the Joint Multi-Role rotorcraft demonstration program. Bell is developing another (smaller) tiltrotor, the V-280 Valor; Sikorsky and Boeing are together working on the SB-1 Defiant compound helicopter, an extension of Sikorsky’s work on its S-97 Raider. Airbus Helicopters had considered bidding its own compound concept, the X3, but were put off by the Pentagon’s demands for its intellectual property. Barring some dramatic development, whatever the military gets next will come from Bell-Sikorsky.

As I noted earlier, it’s entirely possible that Airbus would not object to Textron’s buying Sikorsky. As the Pentagon’s dependency on the Texas-and-Connecticut company would be considerable, its immediate solution to re-diversifying its supply lines could be looking closer at aircraft from Mississippi. The US Army’s enthusiasm for Airbus's low-cost Lakotas looks set to continue, and the US Coast Guard has been happy with its aircraft for a long time. I will not be shocked by an amicus brief against such a deal, and it’s probably a question that Airbus strategists are debating right now.

At best, though, that’s a runner’s-up solution—for both Airbus and the Pentagon. One might even call this mooted company a European-style national champion, and that’s where the problem resides. Buyer behavior could slowly change from encouraging competition to forestalling it. Buying rotary-wing aircraft from Airbus could come to elicit the same sort of political hostility as buying fixed-wing aircraft from Airbus, if supporters of Textron chose to play that card the way supporters of Boeing do today. Would source selectors seek alternatives from Airbus and Agusta Westland, or just presume that they didn’t have any? If so, the deal could constitute a sharp step backwards for transatlantic military-industrial integration.

Is this really what American military procurement strategists would want? From a spun-off and publicly-traded Sikorsky, military buyers would still get their helicopters. A winning bid from Lockheed Martin would still yield helicopters, and maybe fewer fiascos. Should Textron have the winning bid, however, it’s not clear what long-term remedies would support healthy competition for the Pentagon’s business. Change in the strategic conduct of the combined seller, and the quotidian conduct of American military buyers, are hard to gauge in advance.

James Hasík is a senior fellow at the Brent Scowcroft Center on International Security. This essay updates his assessment of 24 June.

The emerging wave of consolidation is yielding more diverse competitive dynamics than emerged from the post-Cold-War restructuring.

Five years beyond the inflection marked by the Great Recession's bottom and Iraq War's end, the market for mergers and acquisitions in aerospace and defense is finally heating up and taking shape. At this halfway point through 2015, the value of transactions this year is approaching $30 billion, a pace roughly twice the trailing ten-year average. The deals comprising this surge have brought into focus three trend lines of corporate development along which we now can discern the first wave of restructuring to the aerospace and defense industry post-2010. Alongside these themes also is emerging a leading indicator of what may form a second wave. To the extent these trends have gone unremarked until now, it owes in part to slack deal flow but also to how the economic and business logic of what deals got done has defied conventional expectations.

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A role is emerging for small firms that connect defense to commercial technologies.

On his recent pilgrimage to Silicon Valley, US Defense Secretary Ashton Carter tried hard to stoke enthusiasm amongst commercial software firms for working with the Pentagon. So far, they’re not buying the pitch. To start, they’re just not interested in ten percent margins and the burdens of the Federal Acquisition Regulations. More so, as a vice president at an aerospace company out there recently explained to me, the problem also lies in Californian culture. “I sell weapons,” she said; “my husband works in the oil business. We live in Santa Monica. You can imagine that we’re really popular with the neighbors.” So there’s a gap, and no amount of hectoring by cabinet officers will close it.

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Should structure or conduct drive the Pentagon’s supply strategy?

The bids for Sikorsky are in. For United Technologies CEO Greg Hayes, they’re “at least as good as what we had hoped to see.” By the rumors, they’re from Blackstone, Lockheed Martin, Textron, and Airbus. With such a heterogenous set of bidders, a range of strategic and financial considerations are driving the offers. The tax implications are daunting for United Technologies, and even strategically arduous for Textron, so a spinoff remains in the running as the best option for shareholders. But military buyers should also care about just how the structure of the rotorcraft industry could change, and what that could mean for the conduct and performance of all involved.

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