The Defense Market is Dying (Not) – Some Great Contrarian Opportunities over the Next 5 Years

The Defense Market is Dying (Not) – Some Great Contrarian Opportunities over the Next 5 Years

According to Anup Shah at Global Issues, defense spending dropped half a percent from 2011 to 2012—to approximately US$1.7T a year worldwide. Many observers are projecting future declines in the defense budgets for North America and Europe of up to 10% over the next 6 years.

Offsetting this decline are defense budgets forecasted to rise up to 4% over the same period in the Asia-Pacific and Mid East North Africa (MENA) market. The net result for the global defense market is perhaps as much as a 5% drop in global spending over the next half-decade–from US$1.7T a year to US$1.62T a year.

These numbers do not show a market with the bottom dropping out–so don’t run away from it too fast!

For those planning to stay and grow in the defense business, many opportunities will arise as others exit the market in fear or significantly reduce their exposure to the sector. The next few years will present opportunities for mid-sized defense firms to expand by acquiring key capabilities with ample prospects for growth.

However, following this strategy to stronger performance in an increasingly globalized defense market will mean concentrating on some key guiding principles.

Here is AMI’s view of some of these “high yield” aids that will help you navigate future defense market conditions:

  1. Be international—not just in name but in deed. This means international is a core focus and company leadership is invested in expanding multi-national operations.
  2. Don’t view the international market as a “foreign military sales” subset to your more important or comfortable domestic market – there should be nothing “foreign” about your approach to the international market!
  3. Be prepared to find and enter non-traditional markets and segments in the global space to generate new revenue and offset flat or declining performance in current core markets.
  4. Find joint ventures or acquisitions that establish and/or grow existing in-country presence and credibility with the local customer.
  5. Work the offset strategy harder—make sure your market approach specifically addresses meeting bigger and harder offset targets now being set by international customers. Unfulfilled offsets are an opportunity and/or a problem—making them a priority early in the business plan helps avoid them becoming the latter.
  6. Help train new buyers—especially among smaller or newer customers–in defense acquisitions/life cycle support strategies. These are the two most misunderstood and mismanaged areas in the international defense market.
  7. Build on your in-place processes that have proved successful in the international market.
    –Refine your Bid/No-Bid process to maximize wins and promote your ability to no-bid. 
    –Identify your “Must-Wins” at least 2 to 3 years in advance to ensure sufficient time for positioning. Allocate sufficient resources for success given higher competitive rivalry. 
  8. In the near term, focus on modernization and upgrades of military hardware as new construction programs are scaled back or canceled in the large advanced economies.
  9. Be mindful of professional services growth opportunities beyond 2015 as a generational turnover is beginning to occur and will continue over the next decade.

Future Focus on Naval Ship Modernization

Most advanced economies in Europe and North America will see static or declining defense budgets over the next decade. For Navies, this means a slowdown and reduction in planned recapitalization efforts of fleet force structures. As older ships receive life extensions and fewer new ships join the fleet, pressure will grow for more maintenance and eventually – modernization.
In the near term, navies will focus more attention on concentrating maintenance expenditures for the most operationally valuable vessels. Disposal of older, more expensive and/or less capable platforms will increase.

Also expect to see continuing investments in “force multiplier” technologies that can help legacy navies stretch their declining platform force structures further. These would include aviation (manned and unmanned, ship and shore based), broad area sensor and over-watch systems, and unmanned surface and underwater vehicles.

The growing mismatch between maritime resources and commitments within many of the world’s navies will spur careful force structure planning. Above all, anticipate more focus on changing ship designs, equipment and concepts of operations to economize in leading naval cost drivers – fuel and personnel.

At the same time, the pace of naval technological change is accelerating – especially with respect to offensive threats posed by precision weapons. The maturation of directed energy in the naval domain will further expand a threat envelope already challenging enough with the latest generations of missiles, mines and torpedoes.

Therefore, as legacy navies economize with more refits and life extensions, the importance of upgrades to combat systems and weapons will surge to the forefront. The watch-word for the coming decade will be “New systems in older hulls,” as the best/only option to keep pace with new threats.

Each month I will be offering up ideas to stimulate change in our naval market. I welcome your comments, suggestions, and critiques. You can reach me at gstitt@amiinter.com, @GuyofAMI on Twitter, or on this Naval Futures website.

Defense Consolidation

April 2013

As the United States (US) and Europe continue to reduce their respective defense budgets, one can anticipate that major armed forces restructuring efforts (and corresponding adjustments in operational capabilities) that have been underway for the past several years will continue.
In order to adapt to this new climate, there is a need for better cooperation between the continents. A recent example of this is the high-level UK-US summit to discuss the preservation of capabilities by consolidating military operations and establishing joint partnerships where practical. (See: http://www.defensenews.com/article/20130330/DEFREG02/303300006/U-K-U-S-Look-Preserve-Capabilities.)

In order to support these efforts, there must also be a corresponding consolidation of defense firms; keeping in mind that “critical skills” must be maintained. With that said, the pressing question is how does this process unfold and what approaches must be taken. The answers will be vital for the future of North American and Europe defense firm’s survival.

In Europe, the EU Strategy for 2020 is guiding much of the region’s way ahead, yet defense funding and cooperation are slow in their progression while industry consolidation still seems to be ill-defined. Although European firms view the establishment of “North American” operations as critical to their survival, restructuring in the US will preclude much more of this from being realized. However, I would expect more joint partnerships and/or international agreements as part of the way forward.

In regards to the US, Congress and the Obama Administration are still too slow in establishing a long term economic plan for the country; which is now affecting defense industries here in the US and worldwide. Representing some 25% of the World’s GDP, a stable economic plan is crucial in order to spur a turnaround of today’s continuing economic recession. Defense cuts have occurred through the Budget Control Act (US$500B over 10 years) and the recent “sequestration cuts” where indiscriminate cuts of another US$487B over the next ten years (2013-2022) is now being enforced. We can be certain a number of US defense firms are now crafting their mergers or divestment plans as we read this.

It would appear that certain key ideas should be kept in mind as we head down this path:
1. European and US defense leadership (both military and industry) must ensure critical skills and capabilities are not lost and that wasteful activities/overhead functions are pared down considerably.
2. While mergers between US, UK and European firms are less likely with defense and industrial firms in “emerging economies”, executives should still pursue joint-ventures or co-production opportunities in these regions, which can serve as a path for:
a. New designs and developments in less critical and less sensitive components and elements of defense systems.
b. Finding access to markets that have been difficult to enter.
c. Establishment of “Super Multi-National Teams”, with strong definitive agreements to collaboratively pursue major opportunities.

Each month I will be offering up ideas to stimulate change in our naval market. I welcome your comments, suggestions, and critiques. You can reach me at gstitt@amiinter.com, @GuyofAMI on Twitter, or on this Naval Futures site.

Emerging Naval Ship Exporters

Key Take Aways;
1. A number of new naval shipbuilders are entering the naval export market.
2. The shipbuilders are generally coming from emerging economies and are competing with advanced naval shipbuilders worldwide.
3. Naval system houses and equipment manufacturers will need to reach out to these emerging builders to ensure full market coverage for their systems sales.
4. There are still some challenges these emerging builders will face in the marketplace.

In the last 6 years, the world began witnessing an expansion of naval ship exporters from those nations with emerging economies. These new yards offer lower construction costs due to; 1) reduced labor rates, and 2) little to no import tariffs on steel and machinery. Those emerging yards winning export bids are generally providing good quality construction at about 10-15% below the costs of traditional European naval builders. For legacy and new naval systems and equipment houses, reaching out to these non-traditional naval shipbuilders is a vital step in maintaining (as well as expanding) export sales of naval systems and equipment.

Perhaps Damen Shipyards in Galati, Romania is the best example of an early entrant of this new breed of naval ship builders/exporters. In 1994, Damen started cooperating with Galati by subcontracting hulls of cargo vessels to the yard. This cooperation worked out very well and in 1999 the shipyard officially joined Damen Shipyards. An ambitious investment plan followed which mainly focused on the improvement of efficiency as well as working conditions. Damen Shipyards Galati was transformed into a modern, top quality shipyard with the capability of building a broad range of products such as LPDs and OPVs. The vessels are built in Galati and final systems integration, testing, and delivery is done by Damen-Schelde in the Netherlands.

Daewoo Shipbuilding and Marine Engineering (DSME) provides another example of high quality, low labor costs, and indigenous designs that are winning major naval export contracts on a global scale, some of which include:
– Four 37,000 ton replenishment oilers for the UK Royal Fleet Auxiliary – MARS Program.
– Three Type 209 Submarines for Indonesia including construction assistance of additional submarines at PAL Indonesia in Surabaya.
– One new (plus one option) frigate for the Royal Thai Navy (RTN).

More recently, several Turkish shipbuilders, including Koç Holdings’ RMK Shipyard and Dearsan have entered the naval export business. Dearsan has a recent win in Turkmenistan with the sale of Tuzla fast patrol boats, and STM is providing the design and material kits to Karachi Shipyard in Pakistan for the construction of an AOR for the Pakistan Navy. AMI is also beginning to see Turkish shipyards as bidders on nearly every worldwide naval tender.

The value proposition these new yards offer is significant savings in labor costs. These savings can run upwards of US$50-60M on the total cost of a modern frigate, some 10-15% in savings.

However, these emerging naval shipbuilders still face some challenges in the world market including;

– Maintaining good quality work.
– Developing well performing naval designs.
– Ensuring selection of good mechanical and electrical solutions.
– Ensuring complete combat systems and weapon integration skills
– Providing through life support for these exported naval vessels and their systems.