Industry Focus: Defence

Global defence spending is declining, resulting mainly from reduced armed conflict in Iraq and Afghanistan and affordability concerns in many traditional militarily active governments. However, defence spending is increasing in several areas of the globe, especially in the Middle East, India, China, Russia, South Korea, Brazil, and Japan. Many of these countries have produced the incremental wealth necessary to equip their militaries with modern defence platforms and technologies. Some of these same countries have threats on their borders or in their geographies, all of which is contributing to an expectation of increased defence spending. However, these opportunities for sector growth are likely to be diminished with the overall downward trend in global revenues for the defence companies, which declined 1.3 per cent in 2012 and 1.9 per cent in 2011. Although the final numbers are not yet reported for 2013, it is anticipated that global revenue for defence companies will track to similar levels as in the past two years, around an estimated minus 2.5 per cent.

The U.S. spends by far the most on defence, with approximately 39.1 per cent of the total global spend. Thus, any reduction in the U.S. defence budget will have a disproportionally higher impact on the global spend. On 1 March 2013 in the U.S. the Budget Control Act sequestration took effect including a US$37 billion reduction in defence spend, and US$52 billion of expected reductions annually for the next nine years. As of this writing, the U.S. House and Senate budget negotiators reached agreement on a budget deal that would mitigate sequestration impacts on military and domestic spending over the next two years, eliminating US$63 billion in across the board domestic and military cuts through 30 September 2015. Notwithstanding, defence contractors have already begun to experience the impact of sequestration. Indeed in 2012, the top 20 U.S. defence contractors experienced a 3.3 per cent reduction in revenues. Through the first nine months of 2013, the top 20 U.S. defence contractors have experienced a revenue decline of 2.5 per cent, a trend expected to continue through the end of 2013. With a signed National Defence Authorization Act of 2014, it is expected an estimated US$22 billion of defence budget cuts in 2014, which is likely to translate into additional U.S. defence contractor revenue declines, slightly lower than that experienced in 2013. Figure 4 shows the four-year history of revenues and earnings for the top 20 U.S. defence firms, as an illustration of the challenges the sub-sector faces in the coming years.

The global defence industry in 2014 and beyond will be challenged in two major ways:
  • how to grow profitably in a declining market; and
  • what actions are necessary to cut costs to maintain acceptable financial performance.

Firstly, with declining budgets, it is likely there will not be sufficient work to sustain current levels of revenues and earnings, requiring global defence companies to find other sources of revenue. Governments are expected to continue to spend on programs of significant value, such as the next generation intelligence, surveillance, and reconnaissance (ISR) technologies. The ability to know, process, and react in real time to events on the ground, in the air, and at sea will continue to be a strategic competitive advantage in armed conflict. The ability to process mega-billions of data bits provided by high resolution optics, communication sensing, and other multispectral sensors, is key to differentiating friend from foe, or tactical threat versus benign events for example. The use of advance data analytics to sift through the data and make sense of it will be another strategic advantage in armed conflict. Innovations in these areas represent a source of potential growth for defence companies.

Defence companies will increasingly be required to invest their own funds in potential growth areas, including next generation ISR as indicated above. Other areas of growth that my help fill the revenue gap are foreign military sales to countries that are spending more on defence. Other promising areas of growth are in cyber-security, adjacent markets, and application of military technology innovations for civilian markets. Lastly, growth is expected to come from inorganic sources via acquisitions. Acquisitions into new markets or consolidation of weaker companies to create economies of scale are expected to accelerate in 2014.

Secondly, in order to maintain margins in a declining revenue environment, costs need to decrease. Successful defence companies have already been anticipating defence budget cuts and have been reducing staff, cutting overhead costs, and getting lean. They are accelerating the substitution of process automation over more expensive labour, resulting in higher operating earnings per employee. Digital product development and computer aided design have been a game changer by creating significant efficiencies in the product development process. Lean manufacturing and six sigma initiatives have significantly cut waste and inefficiency in the production process. It is expected these initiatives and programs will accelerate in 2014 as companies manage their margins and profitability in a declining revenue environment.