Obama Announces New Military "Strategy"

President Obama visited the Pentagon yesterday to announce the nation's new, leaner military strategy. The WP has a summary here, and the full Defense Strategic Guidance document can be downloaded here.

A very short summary:

Special Ops, drones, and cybersecurity. Out of Iraq, but not the Middle East. No more "prolonged" stability operations. Instead, “tailored capabilities appropriate for counter-terrorism and irregular warfare.”  One war at a time. Expect veterans -- especially Soldiers and Marines -- to get shafted on pay & benefits.

Meanwhile, oil could jump to $210 as the "Great Prophet" moves into the Straight of Hormuz.

Save Money by Reducing Regulatory Burden

I wholeheartedly agree with Daniel Goure of the Lexington Institute, who proposes that the US Government could save up to $80B annually by reducing or eliminating needless, ineffective, innovation-crushing acquisitions bureaucracy. 

If this overhead burden prevents $80 billion worth of waste, fraud or abuse annually, it would at a minimum be a wash. But there is no evidence of this. In fact, there appears to be an inverse relationship between the growth in regulations and oversight and problems with acquisition programs and DoD contracting. There has been no reduction in cost overruns, performance snafus, Nunn-McCurdy breaches and procurement/contracting scandals over the past 20 years. Acquisition programs now take two, three and even four times as long to reach fruition as they did in the era before all the regulations were imposed. What are the costs associated with stretching out programs? I bet it is a lot more than any savings that might have been realized through tighter controls over the acquisition process. It is fair to conclude that DoD is suffering from both a surfeit of regulations and continuing problems of waste, fraud and abuse.

Cheer! Too bad no one will listen.

Looking for cuts?

Ouch. This report says:

"Every year since 1996, the Army has spent more than $1 billion annually on programs that were ultimately cancelled. Since 2004, including FCS, $3.3B to $3.8B, or 35% to 42%, per year of Army DT&E funding has been lost to cancelled programs. The Army cannot afford to continue losing funds in this manner."

(via Battleland)

End of an Era in Defense or More of the Same?

Is it the end of an era for defense contractors, or a cleverly masked status quo? There are two articles worth reading at MSNBC: the first talks about a "golden decade" for defense spending coming to a halting end. The day before a related article describes how the twelve senators from the deficit cutting super-committee come from states with large defense contracts.

The six Republicans and six Democrats represent states where the biggest military contractors — Lockheed Martin, General Dynamics Corp., Raytheon Co. and Boeing Co. — build missiles, aircraft, jet fighters and tanks while employing tens of thousands of workers.

but still:

The wars in Iraq and Afghanistan are winding down, Osama bin Laden is dead, and the federal government is deeply in debt. This spells the end of what was a golden decade for the defense industry.

What's the truth? Frankly, the defense market is likely overreacting just as much as the rest of the market. The initial announced cuts of $350B will almost entirely come from planned, gradual troop reductions in Iraq and Afghanistan. More cuts could happen without destroying the cash-rich defense giants at the top of the league tables. Cut the (still highly notional) Ground Combat Vehicle ($1.3B). The JLTV. Sell the deployed MRAP fleets. Cut one tactical platform each from the Navy and Air Force. Overhaul the military's broken retirement pay system. Make Lockheed and Boeing pay for overruns on the F35 and KC-X (I think this is a done deal, actually). Billions. Very little of that will cut deeply into the multi-year backlogs of major defense contractors -- and there will still be plenty of funding for counterterrorism, unmanned systems, cybersecurity, improved soldier systems, TTL, biodefense... and other new technologies that can be fielded fast and can make a real difference in DoD's mission.

Panetta Tells Congress No Further Cuts

Defense Secretary Leon Panetta, along with Adm Mike Mullen, appeared before Congress yesterday and said further cuts to the defense budget -- beyond the $350B already planned -- would be "disasterous" and "unacceptable." More from NY Times here.

Survey Results: Top Content on Defense Ventures

For the past year I've been running a content survey (see right) to get reader feedback on favorite subjects as well as your perspective on the most promising industry sector within defense. For the respondents that were not spamming the survey (!), the answers were very helpful and thoughtful. Here is a look at some key results:

People overwhelmingly prefer the niche content around defense industry venture capital and private equity. This makes sense, considering the surge in traffic whenever there is news or an update about a defense private equity firm or venture capital program. Still some interest in general M&A and surprisingly less so for defense technology (an area where admittedly there are better alternatives, many I have linked to). 

Private Equity / Buyouts 38%

Venture Capital 29%

Corporate M&A  10%

Defense Technology 10%

So from this I will step up the focus on insider PE/VC coverage, especially Player Profiles -- but I will still keep up the other areas and maybe de-emphasize the general industry news (which readers probably already know).

Next up was a more diverse and robust reponse to the question of what sector you thought was most interesting and promising for the future. 62% responded around 4 top choices.

tie UAV / Cybersecurity 17%

tie Soldier Tech / IT Services 14%

I'm glad to see Soldier or Army technology ranking high, as that has been a particular focus area this year, with a range of interesting programs and business potential with relevant commercial applications. I'll continue, though, to keep technology coverage broad since the responses were so spread and no single area really dominating. I can probably do more to cover UAV and Cybersecurity.

One final bit of analysis I find interesting: I started this site a few years ago based on a business school project, but essentially from scratch. A one-man show with no advertising or PPC, Defense Ventures has been a simple collection of ongoing content and commentary. Looking at some basic search results today, I notice Defense Ventures has achieved many Top-10 results rankings for relevant keywords that had limited coverage just 2-3 years ago. Here are a few:

"defense industry venture capital": Google result #1, 2, and 4

"defense private equity": #3 Google result (ahead of Carlyle Group)

"veritas capital": #2 (behind the firm itself)

"defense technology" and "army technology": two results in Top-10 (ok, #9 & 10)

Pretty neat. Thanks for reading and look forward to more. 

L-3 Will Spin Off Government Services Unit

L-3 Communications  announced today that it will spin-off its Government services unit into a separate entity called "Engility." It will also reflag its cybersecurity and defense intelligence business as National Security Solutions.

New name for ITT

ITT announced the new name for its defense business that has been carved out. ITT Exelis.

ITT’s current water and wastewater, residential and commercial water and flow control businesses will become the company Xylem. It will provide equipment and services such as collection and distribution.

The company’s current defense and information solutions segment will become ITT Exelis and provide C4ISR-related products, systems, information and technical services.

Details on L-3 Activist

There's a good article from Reuters on the activist investor targeting L-3 Communications. Relational Investors has accumulated a nearly 6% stake, making it the largest L-3 shareholder. They are seeking a break-up that includes shedding not just the Government services division, but also its aircraft modernization and maintenance (AM&M) business. As the article points out, these divisions account for significant revenues but are substantially lower margin.

The services and aircraft divisions both had operating margins of just above 8 percent in 2010. In comparison, the electronics division's margins exceeded 14 percent, while the intelligence unit saw 11.6 percent in margins.

This case is different than ITT, which was about separating the defense business from unrelated businesses in water technology and industrial components. But with L-3, Relational is going after a company that has tried to diversify across product lines that are all still (tightly) defense related. 

There could be some gain if L-3 were split into multiple divisions and those units would then get acquired at a premium by rivals in a two-step process, some sources said. But what are seen as most attractive takeover targets -- electronics and intelligence divisions -- are where the company wants to focus its growth.

Instead, L-3 would like to do a small divestiture within the services division at this point, separating the labor-intensive military support business while keeping the high-end intelligence and cyber-focused part, people familiar with the matter said.

Relational might have a harder time with L-3, particularly considering that the shares still trade at a better-than-industry-average premium. So inevitably they will have to come forward and offer more details about their strategy.

Activist Investors Target Defense Firms

Former Lockheed Martin Chairman and CEO Norm Augustine once said, "When it comes to diversification, the defense industry's record is unblemished by success." Apparently this idea has enlivened activist investors to push for changes at some leading defense firms, namely the carving out of specific defense businesses from others and from commercial operations.

Forbes has a great article discussing the emerging trend, with details of famed corporate raider Carl Icahn's pursuit of OshKosh and Relational Investors' new assault on L-3 Communications after its succesful campaign to break up ITT. 

So what's happening? Forbes contributor Loren Thompson says outside investors (and increasingly private equity firms) are seizing on financial opportunity in an environment of uncertainty for defense contractors.

It isn’t surprising that outsiders would be taking a closer look at the defense sector these days, because after ten years of steadily increasing military outlays, demand is softening and terms are tightening in a manner likely to generate investor frustration. In such periods of discontinuity, it is easier to convince shareholders that current management teams aren’t doing their jobs well, that strategies need to change, and that major strategic moves should be contemplated. The problem, though, is that the sector’s fortunes are being driven mainly by factors beyond its control, like receding military threats and a ballooning federal debt. So while activist investors may succeed in improving near-term returns to shareholders, that windfall could be bought by undermining the long-term success of the enterprises they target. However fashionable it may be to break up a conglomerate into “pure-play” businesses, something is lost in terms of financial resilience and flexibility.

 While naturally there is some financial opportunism motivating these "outsiders," I'm not sure I agree with Thompson's overall view of the situation that these firms will end up less financially resilient. No, I think something much bigger is happening. The fact is, the biggest defense firms are uniquely great at manufacturing weapons systems -- in highly specialized, heavily designed, monolithic Government acquisitions. This alone is a steadily growing, sustainable, cash-flow positive business with high barriers to entry, even higher since the late 90's industry consolidation. They really should concentrate on that.

However, these same companies are NOT good at delivering services. A principle strategic assumption of the defense industry -- sell big ticket items followed by lifecycle support services -- is absolutely breaking down. The Government doesn't want to buy lifecycle support (or other Government services) from the OEM's. They know this is where the margin (fat) is, and they have responded by restricting this business through tighter conflict-of-interest regulations and a broad demand for more "scalable" platforms and more commercial off-the-shelf technology. These are the divisions that Lockheed and Northrop have been forced to sell, and the same type -- in addition to unrelated commercial business lines -- that activist investors want to see other defense manufacturers shed as well. Then they can focus on their real core business of manufacturing and hopefully do so in a more financially viable way then selling heavy tactical trucks at a loss to get the follow on services business.

This is indeed a MAJOR shift for the defense industry, and one that some firms (Lockheed, Northrop) are already better positioned to face than the competition (Boeing, L-3, Oshkosh). On the back end of this shift, however, is a substantial sea of market opportunity for smaller, more agile and flexible firms to specialize in delivering integrated logistics and other program management services. It makes me think of SAIC's announcement earlier this year that they too would divest some commercial businesses to pursue a "bolder" M&A strategy for defense related services. So far it's not really clear who the leading buyers are -- other than PE Firms -- for these businesses being spun away from the major manufacturers. Will a market leader emerge? Any guess who it will be?