The following article was written for a competitive intelligence industry newsletter – June 17, 2010
There's been a lot of speculation about the 2010 U.S. defense budget. Despite a $21 billion increase, many news reports have focused on the loss of big ticket items, such as the cap on F-22 Raptor production. Additionally, the Future Combat Systems (FCS) vehicle program has been scrapped, as the design would have rendered the vehicles practically useless for combat operations in Afghanistan and Iraq.
Less reported, however, is the fact that the increase in the defense budget will result in an increase in the force structure and a shift in support services expenditures. While a $21 billion increase implies new investing opportunities, there are still potential financial landmines to avoid.
|Source: Congressional Research Service Report |
Defese: FY2011 Authorization and Appropriations, November 23, 2010.
Bob Nugent, Vice President of Advisory Services for AMI International, which provides naval intelligence reports to navies, shipbuilders, and naval equipment manufacturers, reviewed the 2010 defense budget and discussed its implications for the financial investor.
"The DoD (Department of Defense) is making a concerted effort to reorient the direction of the budget towards lower-intensity programs and capabilities as opposed to big ticket items," reported Nugent. "The other part of the reorientation is going towards manpower because both the Marine Corp and the Army have increased their force structure significantly in response to what's going on in Afghanistan and Iraq. So, a larger portion of the defense budget will also go toward personnel accounts."
One effect this shift will have is an impact on the military vehicle market, which enjoyed growth over the past decade. While the military will always need to get around, sales of military vehicles are expected to fall off a bit, as indicated by the loss of the FCS program.
"We're seeing a larger portion of the money going towards things like rifles, vehicles, personnel gear, and tactical communications, as opposed to fighter planes and big cruisers," Nugent stated.
According to Josh Cohen, Defense and Aerospace Analyst with Fletcher/CSI, a competitive intelligence and business consulting firm, “For defense companies, diversifying their manufacturing capabilities can help weather the storm of DoD project and budget cuts, which are not likely to slow anytime soon."
Cuts like a Knife
One wildly publicized part of the budget concerns the production of the F-22 Raptor. Although production of the F-22 has been capped at 187 aircraft, four more than approved under the Bush administration in 2005, planned production has continued to drop over the past two decades. The cap means that the F-22 program will lose 13,000 jobs by 2011.
The conventional wisdom notes that the increase in F-35 production will add 44,000 jobs, more than making up the jobs lost in the F-22 program (both are manufactured by Lockheed Martin). So, problem solved. No worries, right?
Well, earnest investor, don't fire those financial afterburners just yet!
"There may be some shift in resources between the F-22 and F-35, but the F-35 is a troubled program," reports Nugent. "It's not really in a position to replace the jobs lost by the budget process for the F-22. The defense cuts do paint a pretty grim picture for that industrial infrastructure. So, there's significant concern on this issue."
There are industrial infrastructure concerns that will be affected by the future trends in the defense budget, not only in fighter planes and aerospace, but shipping as well. As the government reduces production of high-end, or big ticket, military hardware, highly skilled workers, with thousands of dollars invested in their training and education, may no longer find work that utilizes their highly-specialized skills.
"Very skilled and irreplaceable human resources are going to go away and nobody's coming in their wake," Nugent grimly noted.
An army marches on its stomach, as Napoleon once said, so support services are essential components of any modern military force structure. Extended operations in Afghanistan and Iraq have underscored this need, which for a modern army entails more than just food and equipment.
The 2010 defense budget reduces "support service contractors" from the current 39-percent of the workforce down to a pre-2001 level of 26-percent. However, that doesn't mean the military is cutting back on support the troops in the field, in fact, just the opposite.
Bob Nugent explains: "In the last ten years, large numbers of civilian contractors have taken up those jobs that in past have been filled by people in uniform. What they're talking about doing now is shifting it into a mix of government people as opposed to just civilians. There'll be civilians, but they'll be government service civilians, working for the U.S. government."
This in turn may affect the portfolio of companies which have been providing civilians to perform those services.
“With budgets being cut and competition increasing, those defense and aerospace firms with a keen awareness of their competition’s activities, and the ability to meet the government’s unique requirements, will likely end up winning more contracts,” said Cohen.
One confusing statistic in the 2010 defense budget is the fact that while military construction is going up 19-percent, family housing is going down about 20-percent. Is the military actually cutting housing during a time of extended overseas operations?
"I think the decrease in family housing is a little misleading because what a lot of the services have done in the last ten years has been to privatize military housing," commented Nugent. "The Navy, the Army, and the Air Force are contracting it out, so I'd want to peel back that number on military housing and see how much of that is actually represented by spending on their own properties as opposed to money going to outsource people that are handling construction and maintenance of military housing. So, that's been a trend in the last ten years."
One area of dramatic outsourcing by the military has been in counseling, education, and related base facilities. While the government has been assimilating some of those responsibilities into its force structure in recent years, Nugent feels it’s a trend that will reverse itself.
"I think the military is very happy to have somebody else be their housing managers, their recreation managers, what have you, as opposed to putting government civilians back in those jobs," Nugent said. "If there's an area where I see the trend isn't very pronounced, or the reversal of the trend isn't going to be as pronounced, it’s in an area like support services and family housing."
Analyzing a trend requires a bit more research than scanning the headlines and listening to the latest network talking heads. Certainly, there are cuts in big ticket items, but Unmanned Aerial Vehicles (UAVs) are in high demand and the budget line for the Littoral Combat Ship has increased. Defense electronics will be a growth area, as well as small arms, personnel equipment, and communications gear.
While some support services, such as housing, will continue the trend of being outsourced to civilian contractors, other aspects will be folded into government service, and some others will see a mix of government and civilian workers.
Cohen, of Fletcher/CSI, noted, "We see a lot of requests to look into markets that are not specifically military orientated, such as IR sensors, civilian armored vehicles, remote undersea vehicles, and testing equipment for communications and radar systems. This is definitely a trend, but businesses with little to no experience working with the government need guidance in determining what contracts to bid for and what technology to invest in."
Investing in the defense industry is not a passive activity. It reflects not just the direction of the defense budget, but the country as well. It's more than asking whether we'll be building ships and planes tomorrow. It also means asking whether anyone will be around to build the hardware we'll need tomorrow if we don't invest in those programs today.