Aerospace and Defense: Building for Uncertainty
How Aerospace and Defense Companies Work
Aerospace and defense (A&D) companies build aircraft, ships, spacecraft, weapon systems, and defense equipment. They sell their products and supporting services and sustainment programs to both governments and private companies, but government customers’ requirements generally drive product development priorities. Many of these companies are state owned or state influenced to some degree, and some have grown out of public-private partnerships or government functions that have been privatized.
This discussion is primarily focused on A&D companies that make military and security equipment. Many of the same developmental challenges also apply to commercial aviation and space companies, which may face even greater challenges due to lack of government co-investment. However, this overview is focused on companies that support governments.
A&D companies build systems of immense complexity and risk, commonly working with untested, next-generation technology that they must mature during the product development cycle. They also frequently build systems for very specific customers (often as few as one), as opposed to making generally useful products for many customers in larger markets. In many cases, the system complexity and development risk is so extreme and uncertain that a responsible CEO would never build the system without customer co-investment, for risk of bankrupting the company. This is the genesis of cost-reimbursable contracts (cost-plus) and other risk-sharing government contract vehicles, which the public sector sometimes uses to encourage A&D companies to invent and build new products.
Source: company data
Aircraft, ships, spacecraft, weapon systems, and defense equipment also tend to take a long time to invent, design, and build. Product development cycles are different across different classes of systems, but it is not uncommon for 10-15 years to elapse between concept and fielding. Long timelines magnify risk and complexity for A&D companies. They also increase the importance of having a clear and directionally correct understanding of the future environment in which these products and systems will operate so that their finished product will still be useful when it is fielded. Adjustments are possible, but it is difficult, expensive, and suboptimal architecturally to try and change what you are building midstream.
There is a common argument among non-engineers and laypeople that the United States and other countries should not bother trying to build these systems, because they always cost more than anticipated and never deliver on time. This is a fair argument, but it is important to understand that without some degree of national risk-sharing, leading-edge defense systems would almost certainly never be built. This may be acceptable if all nations adhere to the same policy; if not, a country runs the risk of falling behind in an era where being one generation of technology in arrears can almost assure that nation will be defeated in combat. While we all wish and hope that the 20th century lessons of the waste and foolishness of war have taken hold in the human spirit and that we have grown beyond war, no responsible public leader can bet on that hope. The downside risk is too high.
This then leads to the observation that we need defense equipment and the men, women, and companies who design and build it. These are enduring, great companies, but they operate in an extremely constrained environment, especially as the burden of development risk seems to be increasingly put on the side of the companies. These companies must not only have deep knowledge of their customers and work in context of customer priorities, but also study emerging systemic change agents and anticipate the future environment. At the end of the day, this requires data, insights, and courage to take risks on decade-long technology bets that great companies in other industries would blanch at.
A&D companies face a number of structural constraints that are important to understand when working in and around this industry. We previously highlighted the technical complexity and long product development cycles, which constrain the agility and flexibility of A&D companies.
Another constraint of working with government customers is that you frequently need to get their permission to sell your products in secondary markets (i.e., other countries). Most companies do not face this challenge—they simply invent a great product, build it, then sell it to as many customers as possible. Scale allows them to amortize their R&D costs over a larger pool of product sales, resulting in a lower per-unit cost. Understandably, A&D companies are often not allowed to sell their products broadly, which results in a higher per-unit cost and eliminates efficiencies resulting from economies of scale. This is what it is and is unlikely to change, but it is an important component of understanding how A&D companies work.
An often-underappreciated constraint in the United States is that the risk-sharing contracts that are sometimes necessary to incentivize companies to invent new technologies come with a rule that very specifically limits the profit margins on large development contracts. The allowable profit margin varies but is often in the 3-7% range and almost always under 10%.
Changing Customer Priorities
As government-sponsored entities, these companies also have a requirement to build what their customers want. This requires their customers to know what they want and correctly anticipate the operating environment years into the future. Simply put, that is hard, and government strategists and defense planners understandably do not always correctly identify the systems they will need in an uncertain future environment.
This can create an inherent friction between A&D companies and their customers. Sometimes these groups are aligned throughout the course of long-term development efforts. The Army’s Big Five programs of the 1980s (Bradley, Blackhawk, Abrams, Patriot, Apache) are commonly referred to as the epitome of successful defense product development, as the future requirements were correctly assessed. Other times this has proven more difficult, and government buyers have logically tried to evolve requirements as they watched the environment evolve. This breaks down when applied to long-term complex engineering programs, which as previously discussed do not respond well to fundamental changes during development. This results in the finger-pointing and outraged op-eds that crop up in the news every few months.
To be clear, that is a fine cost structure to run a business at effective scale and is probably envied in logistics and other low-margin industries. The government must be frugal and thoughtfully balance scarce resources among a number of important priorities. But it is important to compare a 10-20% gross margin to the cost structures of the companies that we see as inventing the future. Google, for example, generally operates at a 60%+ gross margin. Even after spending over $12B on internal R&D in 2015, Google’s parent company Alphabet delivered a 22.68% net profit margin, which allows an amazing amount of flexibility to invest in development projects without a government sponsor (i.e., Google Moon Shots).
|IR&D as a % of Revenue||16%||14%||2%||3%|
|Net profit margin||22%||20%||8%||10%|
Source: 2015 10K data
As shown in the table above, A&D companies run structurally different business models, which limits the amount of risk they can take in self-funding R&D projects. The purpose of highlighting this fact is not to insinuate that it should somehow be otherwise but to demonstrate the operating reality of these companies. Regulated profitability constrains self-funded R&D.
Having the government as your primary customer also correlates company growth with government spending. This is fine in times of spending growth but becomes an issue when government budgets contract. US A&D companies, for example, are generally publicly traded companies. Public companies have a requirement to grow, or generally the stock is punished and management is replaced. Markets often don’t care if a US company’s failure to grow is a direct result of a shrinking US defense budget. Those companies have to grow regardless or they will be punished.
This forces US A&D companies to try and diversify both their products and markets. Diversifying products spreads their dependency across multiple budgets (energy, state and local, etc.). Diversifying across products is difficult because of constraints to R&D spending, which is important to build capability. Diversifying markets generally means international expansion, which mitigates the risk of any one customer negatively impacting the business. International diversification is difficult because of national export restrictions.
In summary, these are constrained and difficult businesses to operate, yet extremely important worldwide.
Source: ASD Europe
All companies are different, but there are common imperatives that compel companies who operate in the A&D industry. Similar pressures upon different types of companies can result in wildly different strategies and tactics, but understanding constraints and compulsions helps frame how the industry operates.
1) Correctly identify and align internal investment and corporate development priorities towards capabilities that will be most needed in the future environment.
2) Help your government customers see and believe your assessment of the future environment so that they buy what you want to build.
3) Sell core products into allowed international markets to grow and diversify risk. Focus on 1-2 generations of technology in arrears. Push your host government to allow for license to sell as broadly as possible.
4) Build or acquire businesses to service adjacent markets within your host country to grow and diversify risk. Focus on commercial, state and local, and other government agencies.