2016 aerospace and defence industry trends

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The aerospace and defence (A&D) industry finds itself in an increasingly challenging predicament. In recent years, military spending globally has been under immense pressure; governments around the world haven’t started many significant new weapons programmes, and few are on the horizon. Moreover, for the past decade, departments and ministries of defence have shifted some of their attention to vendors that aren’t part of the core defence industry, particularly technology firms that leaders believe can deliver products within shorter time-frames, with more agility than legacy A&D companies. In this way, defence departments are broadening their procurement activities away from pure-play defence contractors.

In the US, the Pentagon has highlighted this shift – which has not resulted in new spending on commercial technology – with its recent decision to create an innovation department at Moffett Field in California. That is just a few miles from non-defence companies such as Apple, Google, and Facebook. Much of the activity in this initiative is linked to developing lower-cost digital solutions for core military functions such as communications, intelligence gathering, surveillance, and training. Direct competition from Silicon Valley would be difficult for the defence industry to counter. A&D companies are used to a development landscape in which product improvements occur in a linear fashion, not exponentially and continually. Technology companies prefer the latter.

The combination of unexpected competitive pressures and a more frugal customer base is a one-two punch that the defence industry has never quite faced before. And it has prompted many A&D companies to pull in their horns, conserving their capital and returning cash to shareholders in the form of dividends and buybacks – rather than pursuing aggressive innovation or embarking on improving internal capabilities to better navigate shifting industry conditions. These tactics have led to criticism from industry analysts and the US Department of Defense (DOD) itself, which has said aerospace and defence companies should be plowing more cash into R&D, not share repurchases.

Difficult choices

If you are an executive in an incumbent A&D company facing these somewhat atypical challenges, you have a handful of options to consider. One, you can maintain your current role as a builder of defence platforms, and hope the US and global markets for military spending bounce back. Two, you can build a growth plan around product lines adjacent to your primary markets involving digital technologies, such as cyber security. Or, three, you can move fully into the so-called information value chain, including the parts that are dominated by Silicon Valley companies.

As things stand, you might want to think twice before pursuing the third strategy. Many A&D companies, in fact, are rejecting direct competition with hi-tech behemoths. In part, that’s the reason some are spinning off or selling some of their IT development, integration, and services businesses.

At the moment, many defence companies lack the necessary breadth and depth of talent to support the consistent technological advances required in the information value chain. US A&D companies employ fewer than one in every 150 engineers with expertise in autonomous systems, secure communications, artificial intelligence, and machine learning. And defence companies spend far less on R&D (2.2% of revenues on average) than do most US technology companies (7.6% of revenues on average). Defence companies are not going to out-hire Amazon in cloud services or Google, LinkedIn, or Facebook in data science and analytics.

However, that doesn’t mean legacy players should ignore the lucrative possibilities that technological advances offer. Electing the second option, A&D companies can focus on enhancing existing products and product categories with additional IT-based features and simultaneously opening up new channels for equipment sales in weaponry markets related to hi-tech.

In other words, they can be selective about the commercial technologies with which they choose to upgrade their products or that they feature in new equipment, while avoiding head-to-head clashes with the pure-play technology companies. To illustrate a possible approach to this strategy, Airbus Group SE, Europe’s largest aerospace outfit, hopes to tap into technological advances through a side operation in Silicon Valley to provide venture capital for, in the company’s words, “promising, disruptive and innovative business opportunities”.

The era of big weapons programmes may be a thing of the past for now, but A&D companies maintain a special relationship with global defence departments. After years of doing business with the military, defence contractors have learned well the secrets of navigating the halls of, for example, the Pentagon, and have become fluent in the language and expectations of the top brass. That’s a significant advantage enjoyed by A&D firms over less experienced technology enterprises, which may excel at expanding the boundaries of technical capabilities, but which are more inclined to sell off-the-shelf commercial products to the Pentagon than to tolerate the lead times, delays, intellectual property rules, and elbow rubbing that are typical of a long-term defence contract.

A&D contractors can use this advantage over Silicon Valley to take the lead in adding externally developed technologies – even off-the-shelf items – to improve the performance and capacity of military equipment and systems. An obvious example of this is the effort to build an advanced tanker from basic civilian aircraft, but there are numerous other, smaller possibilities as well. For example, the US DOD has made no secret of its enthusiasm for autonomous weapons and systems that rely on human-machine combat learning and cognitive computing. That presents a substantial opportunity for a defence contractor to develop partnerships with companies that specialise in sensors, artificial intelligence, and machine automation, aiming to use these advances in novel ways to build innovative combat devices based on proven designs.

In addition, A&D companies can branch out even further into new military sectors that are driven by IT, but are just new theatres for traditional conflicts, such as cyber defence. In particular, retrofitting big weapons platforms with offensive and defensive encryption and electronic warfare solutions is a logical technology extension of A&D companies’ existing portfolios.

The first option – waiting for defence departments to provide complete clarity as to their future needs and spending plans – is not completely illogical, but it has a serious downside. Historically, the defence industry has been cyclical, and if it continues to be so, spending should rebound in the near future. But when? That’s not clear. The US military is struggling with a considerable amount of uncertainty, in terms of both the global threats it must address and the technologies it will use to address those threats. If defence companies don’t find a way to innovate during this period of uncertainty, they may find themselves increasingly sidelined and bypassed now and not prepared to satisfy Pentagon needs when or if budgetary constraints are lifted.

A caveat, though: in general, companies need to significantly alter their organisations, personnel, and business models to survive a period of exponential change. Just think of the acquisitions that the few surviving telecommunications companies had to execute and integrate in order to stay on top after the breakup of the 100-year-old Bell System. Or consider IBM’s reinvention as a service company after the mainframe market collapsed in the 1990s. Operating in a relatively orderly industry – at least until recently – A&D companies have limited experience with this kind of sweeping internal or cultural change.

Importing innovation

To deal with this shortcoming, aerospace and defence companies might need to take their cue from the pharmaceuticals industry. To a great degree, the biggest global drug-making companies have maintained high levels of new product development in simmering disease areas by acquiring smaller firms whose research has targeted these patient populations. In these deals, along with pharmaceuticals aimed at promising markets, drug-makers imported aggressive, collaborative, and creative attitudes that had begun to wane in the larger organisation. In similar fashion, A&D companies should consider taking full advantage of partnerships they develop with commercial technology firms by also assimilating critical aspects of their innovation culture, an essential capability for A&D firms facing a period of flux.

Defence companies, particularly those in the US, have a few extremely important things going for them. The first is the bedrock support that they have from their core customers, their governments. The second is their history of technology innovation and engineering prowess. The third is the reliability of their cash flows. Although the “change curve” is starting to slope up more quickly, defence is not a market where a one-for-one replacement product is available that can crumble the economic foundation of incumbents overnight. The disruption that lies ahead, gradual as it may be, will leave the market for traditional defence companies intact for the foreseeable future.



But, there is a risk for defence companies in becoming complacent, and more importantly, there is an opportunity cost. Looking out a decade, we suspect that A&D firms will be in a leadership position only if they have demonstrated the clear ability to innovate amid uncertainty. Now is the time to find ways to get into a race that’s already begun.