Setting the Stage: How the Defense Industry Can Approach Strategic Planning During Increased Uncertainty

A conversation with Pierre Chao, Founding Partner, Renaissance Strategic Advisors

The defense industry continuously looks at the landscape and assesses if we’re at a pivot point regarding defense budgets. You’ve heard about tectonic plate shifts in the marketplace that occur. Once in a generation or so, a major inflection point in the industry occurs, and I think that’s one of the key questions that everybody is asking from a defense strategic standpoint. Are we in a pivotal turning point?

The last major pivot point was the terror attacks on 9/11 which created a really significant shift, not only in terms of total spending on national security but also for the redefinition of national security to include domestic security. There was also a shift in terms of where money was going and created entire new institutions to support that that shift (e.g., the creation of the Department of Homeland Security).

In today’s world, the war in Ukraine has triggered some shifts to the extent that are we returning back to a period of where we’re in a different global threat environment than where we’ve been in the last year. The defense industry hasn’t seen this since the end of the Cold War relative to state on State conflict.

So we would argue there’s five key strategic questions that most companies should be asking and or are asking, as we consider these topics.

The first strategic question. Do you believe that defense budgets are going up or down? What’s interesting is that I think, as you go around Washington, DC there’s still quite a lot of debate going on, whether the broader macroeconomic environment and deficits that you know, will put downward pressure on the budgets. And will it become a Lucy and the football sort of a situation where the other parts of the environment, whether that’s the national security pressures, the pressures for recapitalization, the messaging that’s actually coming out of the Pentagon itself in terms of a need for a new generation of technologies and spending that’s putting the upward pressure is that overcome or not?

It’s probably one of the most fundamental questions that you can answer to the extent that they are higher. There’s hiring, there’s capital investment, there is a recapitalization frankly of the industrial base as well as R. And D. spending decisions to be made over the next 12 to 18 months. If we think that we are in an upward trajectory in the past, when budgets have gone, when upcycles have gone, they have gone, and you know, in other words, there’s usually not a stagger stop. And if one believes that we are in an upwardly sloping environment, and that we are in a new outcome then seeing a trillion dollar defense budget, is not that crazy. ultimate numbers is a reliance on Congressional plus-ups that creates a particular environment. In terms of how to position yourself to protect programs, how to see growth, versus one where the entire desires of the building are manifested inside the budgets, and there’s, limited, tweaking. And over the last 40, 50 years you’ve seen this balance of power shifting back and forth between those that were very congressionally driven budgets. I’d refer back to Congressman Aspen days, for example, versus other environments, say the Reagan build up that was driven by the administration. It’s a strategic question that in terms of how much to rely on the presidential budgets versus “I really need Washington operations to step in and drive things forward.”

On the other hand, if you don’t believe that budgets are going to go off the normal oscillating and curves in terms of the ups and downs this would indicate that you know the downside. It’s got a couple of 100 billion dollars below where we are today. So that’s why it’s such a critical question to answer. It’s the primary question. I would note that: I’ve been doing this poll now for the last six months. This is probably the most bullish group that I’ve seen out of most groups in town. So I take that as an interesting sort of point.

The second strategic question that you’ve got to ask is given the spending that is underway where will it be allocated? What will go on underneath the top line? Will those dollars end up supporting and sustaining and modernizing existing platforms? Will we invest in the old or the current quote unquote, or is it going to disproportionately favor new technologies, new environments? There is considerable discussion and talk about innovation and the need to bring in new technologies. And yet, when you actually look at the raw dollars for sustaining current platforms, current systems and extending the production lines versus a shift towards very heavy R.&D towards a new generation of technologies, and how long that takes.

So it’s certainly a strategic question, because if you’re a second or third-year supplier into the primes it feeds into the questions of which programs do I support? Where do I invest? Do I lean forward or lean into this debate of old versus new?

The third strategic question we think you should be asking is will this environment over these budget decisions be Pentagon administration driven or congressionally driven to the extent that if it’s an administrations that puts out certain budget dollars or requests and they’re modest relative to an upturn and the only way that you get to these

The fourth strategic question, and we heard a lot of elements of this from Dr. Carlin’s conversation is will the growth and the opportunity be more driven by US budgets or international budgets? So is this upturn going to be domestically driven, or internationally driven? We say that because if you were to take all the promises made, for example, by the European countries in the wake of the Russian Russians invasion of Ukraine and take it on all at face value that they will increase, defense spending, that sum total increase over the next 5 years is almost a trillion dollars of incremental spending which is really significant. It would be a level of spending that has not been seen in decades versus taking a look at what US defense budgets could be doing, which may be about equivalent size, let alone what’s going on in in Asia. And the increased defense spending that you’re seeing, coming out of Japan, for example, South Korea, and others. And so, while the last few cycles have favored just focusing in on US defense spending and the industry has typically turned to international sales usually in downturn, or when things slow down. Depending on what your view is of that global growth that would dictate, potentially, very different strategies, in terms of which markets to be addressing and not. It was striking again in the exchange between Dr. Carlin and David, on how much was spent on international. And the phraseology, that is embedded inside the National Defense Strategy which talks a lot about reliance on the Allies and a common set of capabilities etc., speaks to a far more kind of global market from that perspective or global opportunity hen perhaps we’ve seen in a while for high end weapon systems and platforms. It also then derives into industrial strategies in terms of do I need capabilities actually overseas, or do I address them via joint ventures and partnerships co-development? And I need the entire policy framework to get aligned in order to do that.

As a side note, for example, that there was a conversation about having to get it and sort of working. And yet, for well over a decade, there has been a US, UK, and Australia, a defense technology sharing treaty that was passed but hasn’t been really used. And so I think the keep pushing of the environment it’s going to be critical to it’s opening up that. And once again everybody will have to answer the question of do I believe there’s going to be equal opportunity internationally versus domestically, in terms of setting up the strategy.

And then the fifth question you’ve got to ask yourself is Ukraine the precursor, or the harbinger of future fights or not? It is certainly an event that is waking up the world. It’s an event that is creating that tectonic plate shift. But the issue becomes, is it? Is it the equivalent of the poor war right before that was not a proper signal of what a conflict looks like, as we head into the First World War to the extent of First World War. It ended up being a very different fight than that one versus the Spanish Civil War where concepts like, let’s create and other things. We’re being tested out there and it very much turned out to be the harbinger of how you know the Second World War was going to be fought. So which lessons from Ukraine are relevant, not relevant in the next conflict, which ones will be, in terms of how the fight occurs. It’s a pretty important question to be asking. There’s lots being written today about lessons learned about what we should take, not take, and I think we need to sort of pay very, very close attention in terms of making sure that we understand, you know which lessons we should be taking forward as enduring or universal ones versus very specific to the to the fight at hand. So, these are the five questions. I think answering them, then gives the guidepost in terms of how you want to be setting strategy or driving strategy. As many CEO and senior manager teams and boards will sit there and say it’s nice to ask the questions, and you need certain answers, but you can’t wait for 100% clarity. There are decisions to be made today in terms of capital allocation, in terms of M&A activity, in terms of investment decisions on R&D, in terms of where to place bets relative to technology, that we have to accept the imperfect data that we have in order to move forward because there is a risk of if you wait too long in order to make those decisions, then the upturn will be behind us in many ways.

Mr. Chao is a founding partner of Renaissance Strategic Advisors and a co-founder of Enlightenment Capital. He brings three decades of aerospace/defense strategy management consulting, investment banking, equity analysis, investing, and policy analysis expertise. Prior to establishing RSAdvisors, Mr. Chao was the Director of Defense-Industrial Initiatives at the Center for Strategic and International Studies, a Washington D.C.-based, non-partisan defense and foreign policy think tank, from 2003-2007; where he still remains as a Senior Associate.

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