The (U.S) Defense Dilemma: Finding Growth Opportunities

Courtesy- Booz and Company
www.booz.com

Posted by-Neelam Mathews

Dec 11, 2011

In defense, large segments of the industrial base may disappear as spending shifts from investment in research, development, and production of new capabilities toward services and support for older platforms and systems. "Our analysis suggests there are scenarios in which military investment spending on new acquisitions and R&D could decline from $253billion in 2008 to as low as $150billion in 2016," says Booz. With backlogs continuing to erode, underinvestment in R&D threatens to create a hollow industrial base lacking the essential capabilities to develop innovative technologies and build new weapons systems.

As the defense industrial base weighs the implications of these changes, four capabilities will be necessary to establish essential advantage.

First, the Pentagon's emphasis on affordability for developing and acquiring new systems has attracted an influx of nontraditional players for ground vehicles, ships, unmanned aerial platforms, and other systems. There will always be a need for "exquisite" systems, but not in sufficient numbers in the near term to sustain traditional platform builders and their suppliers. Those that wish to compete in today's climate must focus on improving affordability and maintaining cost fitness while establishing long-range plans grounded in the grim realities of the next five to 10 years of reduced demand. In particular, companies that anticipate program reductions and employ a business model that variablizes overhead and manages it down as direct labor hours decline will be better positioned in this market environment.

Second, in the coming years, defense markets will offer fewer avenues for growth, and many companies are evaluating both commercial and governmental adjacent market opportunities. But new markets-with different acquisition approaches, regulatory demands, selling cycles, and customer expectations-will require new operating models, and may significantly change the role of the corporate center. In many cases, defense companies may need to shift from a central operating model to a portfolio management model that allows individual business units to adapt to the unique requirements of their markets. Differentiation could start to emerge as some companies develop a corporate center model capable of providing strategic and financial guidance to a broader portfolio of business units and go-to-market models, while imposing central costs no higher than those realized by stand-alone specialist businesses. In some cases, this could mean significantly scaling back the size and role of large corporate centers.

Third, as corporate leaders plan their expansion into new markets, they will need to develop an investment and diversification strategy that builds confidence in their ability to bolt on adjacent businesses in a way that creates value without adding complexity. This will require careful understanding of the value creation mechanisms that are best suited for new markets, and identification of those that are beyond the capabilities of their own legacy defense businesses.

Fourth, not all defense programs will thrive-or even survive-the continuing downturn. No one likes to think that their program will be in jeopardy, but top-down budget pressures ensure that some programs will indeed be affected. While defense companies are known for their ability to execute large, complex programs, the responsibility for evaluating the broader risk across all the programs in the corporate portfolio must reside outside and above the programs. Business unit and corporate CFOs should fill this role, but may require a higher level of dynamic risk management capabilities. These capabilities would allow the CFO to "peer into" programs and develop an integrated view of overall portfolio risk.


The Commercial Opportunity: Exploiting Record Growth

In commercial aviation, the industry is poised for renewed growth, but its structure will continue to evolve. In recent years, the Boeing-Airbus duopoly has wielded considerable power over a somewhat fragmented supply base, but the duopoly is vanishing as a host of foreign companies, some with state support, are poised to enter a market that exceeds $200 billion and is expected to grow annually at a rate of 3.6 percent over the next 20 years.

Emerging airframe competitors are already beginning to see a shift in the competitive landscape, including a shortening of the innovation cycle and an increase in R&D spending. In addition, the service life of aircraft will be reduced as airlines opt to buy newer, less expensive narrow-body aircraft rather than further extend the lives of existing aircraft. While total cost of ownership will continue to be the principal metric for differentiating airframes, new approaches will become essential. For example, Commercial Aircraft Corporation of China Ltd. (COMAC) could emerge as a low-cost value player, and others may choose "co-opetition" models in which competitors on one platform cooperate on another. Airframe manufacturers should fully explore the impact of different competitive models to understand how customer choices could affect their traditional base.

Suppliers will also see dramatic changes requiring measured responses on their part. They should plan for a shorter services stream on installed base, due to the shorter service life of aircraft in the future. In addition, market power is shifting toward suppliers, due in part to the consolidating supplier base and growing number of airframe manufacturers. As a result, suppliers should expect more risk-sharing partnerships with original equipment manufacturers (OEMs). Equally important, Tier Two and Three suppliers, particularly those that provide standardized products, could increase the amount of value they capture in this new market, while Tier One suppliers may see a decline if they start aligning exclusively with OEMs. Given this expected development, Tier One suppliers should consider where the power lies in the supply chain structure and, where appropriate, consider a shift down the value chain to increase their profitability. In doing so, suppliers will need to aggressively manage changes in demand and inventory levels to provide appropriate levels of service.

United Technologies Corporation's agreement to buy Goodrich Corporation for $16.5 billion is the latest signal of supply-base change. With the purchase, UTC's revenue will exceed $60 billion, giving it considerable heft in dealing with airframe manufacturers. As consolidation continues, Boeing and Airbus will need to think strategically about their supply chain relationships and determine whether closer strategic alignment with suppliers will help maintain advantages in future designs. In addition, many would like to see Boeing and Airbus respond to the new airframe challengers with radical narrow-body designs, but airlines need efficiency improvements sooner rather than later. Consequently, many of those improvements are coming from the supply base, offering a significant opportunity for suppliers with the strongest capabilities in research and innovation.

Finally, we should note that maintenance, repair, and overhaul (MRO) companies may also need to adjust their models as the airlines begin retiring aircraft sooner and rely on new, low-cost narrow-body aircraft. The earlier retirements will require MROs to develop an integrated products and service approach that enables them to extract value for their capabilities over shorter time frames in an increasingly global market.

Addressing these challenges will require different competitive models and capabilities than airframe manufacturers and suppliers have employed in the past. Incumbents will have to adapt their "way to play" (their approach to creating value in the market) by anticipating potential competitive scenarios and sharpening their value proposition.

Look Before You Leap

Even in a growing market, changing conditions require companies to carefully assess their positions to determine the best course of action. Whether companies pursue new markets or attempt to expand globally, they should resist the temptation to simply target the largest opportunities. Successful companies begin by carefully considering their differentiating value proposition and "right to win" capabilities-that is, the qualities and characteristics that create value for their customers and distinguish them from their competitors. They should ensure that their operating model and product and services mix are aligned to support and enhance these core capabilities. This strategic alignment-which we call the coherence premium-enables companies to invest wisely and to execute effectively. Coherent companies also are better prepared to target customers that will value and reward their products and services the most. By focusing on what they do best, they are well positioned to assert their right to win in evolving aerospace and defense markets.