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What industry leaders should know about defense outlook and priorities


Large-scale, state-on-state violence in Europe has shaken the underpinnings of the global security market.


Three questions to ask

  • How should industry respond?
  • On what should business leaders be focusing?
  • Where should time and resources be directed to maximize returns to shareholders and employees?

With significant national security issues at stake, the industry is at a generational inflection point.

The February invasion of Ukraine has shaken the fundamentals of the defense business world. Once-solid assumptions about the dynamics of national security are now in question. In response, countries will change how they budget and procure defense capabilities.


1

Chapter 1

Threat environment

Government spending on defense capabilities fluctuates with perceived threats to national security.


In a heightened threat environment, more resources flow to develop and strengthen capabilities to meet threats, benefiting the firms operating in this space. As threats are resolved or abate, spending abates with them. The cyclical boom-bust of the defense industry lives amidst this world, seeking to maximize revenues when budgets are rising and learning to adjust in the inevitable declines that follow.

The Ukrainian war has heightened threat perceptions in the US and Europe. In response, the US and North Atlantic Treaty Organization (NATO) nations are responding with material and financial commitments to Ukraine and each other (e.g., additional US troop deployments to Eastern Europe). The US military is leveraging current system and equipment stockpiles to provide direct aid to Ukraine fighting forces and improve their prospects for victory. The US is actively purchasing new equipment for immediate use by allied forces and attempting to replenish its own depleted stockpiles, requiring substantial financial investments and coordination with the large US industrial base.

By contrast, decades of inadequate defense spending has left many NATO nations incapable of mustering the bare minimum of material necessary to aid Ukraine and prepare their own response to escalating threat concerns. With many countries perennial under-spenders, rhetorical commitments to meeting 2% GDP targets represent real change. Multiple NATO countries are planning to spend more in view of current events.

Moving beyond Europe, Asia’s defense issues are growing as China and Russia explore the limits of their partnership. Long-standing issues about Chinese intentions toward Taiwan, the Himalayas and the East/South China seas may force regional players to shift from passive to active planning in extreme scenarios. US “Quad” partners India, Australia and Japan can lead the way in the region.

In South America and Africa, threat issues abound, with the potential for interstate and ethnic conflicts, as well as transnational criminal concerns. China and Russia have each increased the depth of economic and security relationships on both continents and will likely continue those efforts. With US and NATO resources stretched and focused elsewhere, these regions may be at higher risk of security concerns.

 

Defense spending in the Middle East will continue to be driven by long-running sectarian tensions and concerns about nuclear proliferation. Changing security relationships could also make it more difficult for US firms to continue their role as a leading export partner without committing additional time and investment.

 

For US defense companies, this may be reflective of broader changes to traditional export markets. Russia is likely to offer discounted equipment to sustain domestic industries. China is already aggressively competing for expanded market access globally – a trend that will only continue. The availability of adequate, commercially derived solutions will expand as technological sophistication increases. Additional NATO spending could push European governments to promote exports as they seek to leverage the potential of scale at home. This makes a lot of sense for strong manufacturing and exporting countries, like Germany. Collectively, these factors imply that traditional US export dominance is not guaranteed, even among close partners.

2

Chapter 2

Enduring requirements

For the past decade, many defense commentators have suggested a “keep your powder dry” approach.

With declining commitments in Iraq and Afghanistan and divergent perspectives on threat, it was not clear whether defense spending would endure or whether cuts would ensue.

However, US defense plans have been largely consistent since 2017, with an increasing Asian focus, a critical role for more robustly funded allies, a commitment to the industrial base, and the identification of must-win military technology areas. While the sudden need for additional commitment to NATO’s territorial defense will stretch resource demands, it is a commitment that is complementary with existing priorities.

There is a broad consensus on these national security priorities and the need to resource them appropriately. As a result, the current environment offers more certainty for western defense firms than they have had since 2001 and perhaps as far back as 1981. Absent significant changes to the threat environment, we would anticipate this certainty extending through the short to mid-term.

3

Chapter 3

Defense budgets

Defense budgets in the US and Europe are positioned for growth.

Spending has four major drivers:

  • Broad national commitment to delivering on strategic aims, particularly in Asia
  • Weapons and logistical support to Ukraine that will need to be backfilled in Western stockpiles
  • US/NATO-supported increase of operational readiness in Eastern Europe
  • Response to inflation that is already actively eating into defense purchasing power

Since 2017, the US Defense Sector budgets have grown at an annualized 3.8% rate despite divergent political backdrops. Most recently, the FY22 US Defense Sector budget increased 6.6% over FY21 as Congress pursued invigorated spending on multiple priorities. In addition, in FY22 the US Government is leveraging ~$23b in appropriations[1] to support Ukraine; reflecting a long-term commitment to directly supporting military efforts there. Finally, inflation will be an enduring factor as military and industry leaders are deeply concerned about the negative impact of inflation running >8% and the impact on real growth.

Therefore, we anticipate the FY23 topline US Defense Sector budgets at or above $840b, a ~12% y-o-y increase. To mitigate long-term concerns about inflation we see this commitment to spending continuing with perhaps 3%-4% annual increases for several years. This scenario could see >$500b of additional unplanned US defense spending over the next five years. While inflation will certainly hurt real growth, this would represent a step change in defense spending.

Concurrently, multiple NATO countries have stated an intent to increase spending and, in many cases, close their spending gap vs. the 2% of GDP threshold. If underspending countries reached 2% of GDP by 2026 and others held defense budgets constant, one scenario indicates there could be as much as $300b-$400b of additional spend over the next five years. Despite challenging immediate economics, multiple European countries are pushing ahead with solid defense investment plans.

Collectively, this means that by 2027 the US and NATO could see >$800b of incremental defense spending vs. previous projections. Across the rest of the world, the knock-on effect is likely to be more spending in other geographies as well.

4

Chapter 4

Military capabilities

Defense planners have the flexibility to invest in strategic priorities and address urgent concerns.

The US Defense Sector has defined several capability areas as critical to enabling warfighting in a large-scale conflict vs. a peer adversary. These investment areas include, but are not limited to:

  • Strategic Systems
  • Space
  • Command, Control, Communications, Computers, Cyber and Intelligence, Surveillance & Reconnaissance (C5ISR)
  • Precision Strike
  • Hypersonics
  • Manned/Unmanned Teaming (MUMT)
  • Naval Forces

Concurrently, the US Defense Sector has defined several must-win technologies that will be critical enablers of the future force. These include cyber, autonomy, artificial intelligence/machine learning (AI/ML), materials and micro-electronics. Moving decisively in these areas is vital to establishing a strong long-term presence in future programs.

Given budget constraints, these capability and technology priorities would imply fewer resources for legacy capability areas such as infantry systems and armored vehicles, among others. However, these capability areas are likely to get a second look given the current conflict. Two factors could drive this change in thinking. First, these capabilities might be a better fit for US/NATO needs in direct support of land-centric European operations. Second, lessons learned from the current conflict could directly result in new applications for many systems.

At the core of delivering on the promise of this strategy is commitment to substantial investment into the productive outputs of the defense industrial base. Much effort has already gone into shaping policy that will support dominant players, incentivize new entrants into the market and improve the ability of the industry to deliver for the future.

In return, industry has responded through distinctive strategies that have evolved over time. Post-9/11, firms launched new businesses around expeditionary services, UAVs and counter-IEDs. Later, as defense demands changed, there was a rationalization for splitting product and service businesses for purer play efforts, along with other changes.

We have already seen some distinctive moves by defense players:

  • Traditional service players acquiring high-technology product businesses
  • Mixed industrials establishing, re-establishing, or expanding their presence in defense
  • Vertical integration in pursuit of affordability
  • Traditional product businesses expanding into high-end services

In the current environment, we expect to see more striking moves from defense players as governments provide clarity into their long-range plans and expectations.

5

Chapter 5

What to do

A complicated security environment holds strategic and operational meaning for the defense industry.

With the backdrop of a complicated and fast-changing market, EY sees five priority focus areas for business leaders:

1. Big changes, big moves.

The addition of up to $800b of new spending and radically increased demand is a transformational industry opportunity. And investors know it. They will expect defense firms to make the most of these big opportunities and accelerate growth. For mid-market firms, strategies to “double in five years” that were a stretch with tighter demand, are likely to be more achievable.

This means big moves should be on the table. A fresh look at investment initiatives that looked unattractive amidst a relatively flat market can be revisited with new, and perhaps more favorable, projections. Engaging partners and advisors involved in strategy, transactions and diligence on the pace and impact of change will open up new potential. M&A could get a new look. Current spending will likely result in new fast-growth streams that were not previously identified on the inorganic growth roadmap. Where vertical integration is impossible due to a tighter regulatory environment, portfolio breadth could be reconsidered.

Cleansheeting toward a radically redesigned program execution paradigm might be appropriate to change p-win probability in this fundamentally new environment. And it could be time to maximize value creation around environmental, social and governance (ESG) or other enablers in tax and contracting that were previously unattractive.

2. Significantly improve program performance.

Incumbents need to stabilize their performance on current franchise programs to minimize the chances that their program will wind up on the chopping block. There are immediate opportunities to improve supply chain stability, drive affordability in materials and improve efficiency and predictability across operations. Digital enablement and connected assets are opening up possibilities as diverse as ML-based forecasting and proactive digital twin “what-if” analysis.

Challengers can demonstrate fundamental improvements in digital engineering and manufacturing, as well as service delivery, to highlight the cost reduction and capability delivery opportunity that a new competitor might deliver vs. an underperforming incumbent. The entire market will be challenged to meet market expectations at the top and bottom lines. Steady performance improvement will remain a key attribute of high-performing defense business.

3. Get ahead of risk.

A new wave of accelerating demand, coupled with inflationary prices pressures and talent scarcity are exacerbating current supply chain challenges. Interconnected markets moving at an accelerated pace require comprehensive understanding of the business networks directly impacting how products flow.

Solving for this new environment is possible leveraging new data and solutions. AI-based approaches can automate risk identification, allowing firms to shift the bulk of their efforts to mitigation, sustainment and focusing on long-term strategies. The opportunity set spans compliance, parts identification and progress toward end-to-end bill of materials visibility.

Geopolitical risks are proliferating and need to be managed. This requires clear focus from the board and leadership to identify and shape issues affecting their business. A broad, nimble and dynamic solution to understand the global context for the business is necessary in times when issues are evolving rapidly across borders and networks. For firms with significant international business, an aggressive effort to understand how these issues affect local franchises and export markets is vital. With an ever-changing regulatory landscape, there are potential new approaches to creating distinctive sales channels.

4. Drive innovation.

With clearly identified technology priorities, firms need to refine their approach to innovation. Understanding how agencies and programs are investing is vital to building a clear perspective on the firms’ technology line of advance: Where do we play? How do we invest? What underpins competitive advantage? These models should be actively informed, not only by defense activity, but also by the latest market movements, including commercial investments, patents and transactions.

5. Win the race for talent.

Wage and benefit gaps will continue to be persistent challenges, particularly in cutting-edge technology areas. Key demographic and recruiting pools are facing headwinds that are unlikely to relent in the near term. These pressures offer a chance to fundamentally reshape the value proposition for employees. Defense firms need to present themselves differently to future talent pools.

Revisioning the employee journey will challenge legacy talent perceptions and programs. The journey becomes a whole of company effort that is more analytical and far more targeted in the past, with local talent and geographic realities shaping decision making and investments in real time. With challenges impacting industry revenues today, levers exist to deliver immediate access to new talent and diminish attrition pains. Longer term, firms will rewire operating models to synergize tech and talent towards more powerful outcomes. Coupled with industry efforts to position as leaders within the growing ESG field, defense firms are well positioned to offer something new to future talent pools. A compelling revisioning of the business and how it functions will be vital to the future of talent acquisition and retention.

For more information on the topic, watch the webcast here:

Summary

This opportunity will demand leadership evaluate aggressive moves to establish the next wave of franchise programs. Embracing risk, investing into digital and securing the best talent will be key to competitive advantage in the decades to come. Capital market expectations are likely to be high. Building new franchises and securing top-tier valuations will require ongoing commitment to program performance, with a relentless focus on schedule, affordability and value for the end customers. With huge stakes ahead, firms that move boldly and execute will separate winners from losers as the next generation of defense leadership takes position.


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