Executives in the defense technology ecosystem continue to experience rising costs and supply chain disruptions. However, growing international demand and technological innovation are driving optimism and investment for the future.
The executives shared their perspectives recently in earnings calls that covered their companies’ first-quarter results. Four themes emerged from the calls, transcripts of which were provided by Bloomberg:
Inflation: Contract types affecting customer outcomes
Continuing price increases are affecting companies differently depending on several factors.
Teledyne Technologies has been able to offset much of the impact through corresponding price increases to customers, said Chairman, President and CEO Robert Mehrabian. He said on April 27 that the company has experienced a 3.5% increase for goods and 3.25% for wages.
Contractors with fixed-price contracts are suffering more than those with a higher concentration of cost-plus contracts. Chris Kubasik, vice chair and CEO of L3Harris Technologies, emphasized on April 29 that the indices used in contract escalation clauses (if present at all) are probably less than the inflation we are currently experiencing. Therefore, there is only so much damage control possible for current contract pricing.
Contractors are using all strategic tools at their disposal to combat margin pressure, including leaning on long-term supplier contracts, redesigning products and offsetting via productivity enhancements.
Mercury Systems President and CEO Mark Aslett shared a similar sentiment on May 3 but noted his company has shorter production cycles, allowing it to more frequently pass on price increases.
Contractors are using all strategic tools at their disposal to combat margin pressure, including leaning on long-term supplier contracts, redesigning products and offsetting via productivity enhancements.
But executives have their eyes fixed on the future. Mercury Systems, for example, is in the process of developing a pricing center of excellence that will “leverage best practices in both pricing and cost estimating across the business,” Aslett said, and implemented a new artificial-intelligence-based tool that will “enable much greater automation and analytics in the procurement process.”
Supply chain: We still need chips
Supply chains are improving, but electronic component shortages remain problematic. Limited supply, few substitutes and long lead times continue to throw a wrench into project planning and delivery.
Kubasik of L3Harris communicated little change in his view of supply chain issues—including inflation, materials and labor—aside from the length of the recovery pushing from 2022 to 2023. He went on to highlight extended lead times for electronic components, freight and shipping challenges, and increased shipping costs.
Electronic component shortages remain problematic. Limited supply, few substitutes and long lead times continue to throw a wrench into project planning and delivery.
President and CEO Rex Geveden feels as though BWX Technologies has “avoided any big consequences of the supply chain disruptions,” but he noted the prevalence of material lead time “hiccups.” He cited an example of having something as small as a digital probe fail and waiting two and a half weeks to get a new probe that would have been delivered the next day prior to the pandemic.
General Dynamics CEO Phebe Novakovic said she believes the company has worked through most of its lingering supply chain issues but is now contending with pent-up demand resulting from last year’s chip shortages and delayed deliveries.
Finally, Raytheon Technologies Chairman and CEO Greg Hayes described supply chain disruptions arising from the Russia-Ukraine war. Global sanctions on Russia halted Raytheon’s supply of titanium forgings and castings, creating a new material shortage in the industry.
International demand rises
International budgets are trending up, especially in NATO countries, L3Harris’ Kubasik explained. Other executives concurred.
“We believe we’re experiencing a sea change in defense spending and priorities with profound implications for the U.S., Europe and our allies both in the short and long term,” said Aslett of Mercury Systems.
A broader response from allies looking to support Ukraine, particularly NATO countries signaling increased defense spending, suggest greater international demand in the medium to long term. Aslett went on to say that Mercury Systems’ advisors estimated $1.5 trillion of potential increased defense spending over the next decade because of U.S. growth and NATO countries more aggressively targeting the 2% GDP defense spending threshold established in 2014.
Mercury Systems’ advisors estimate $1.5 trillion of potential increased defense spending over the next decade because of U.S. growth and NATO countries more aggressively targeting the 2% GDP defense spending threshold established in 2014.
As a result, contractors have shifted priorities to assist the federal government in providing support for the Ukrainian government as the war continues. This could mean greater demand for military systems that have been out of production for some time. Restarting production on an outdated weapons system that has not been produced in many years will be far more difficult than shifting back to a slightly older version of a current system, Kubasik said.
Maxar Technologies is experiencing increased demand for its satellite and data services in light of the value Maxar has demonstrated throughout the Russia-Ukraine war, CEO Daniel Jablonsky said May 9. He added that Maxar is well positioned to provide government entities information to “better understand what’s going on in every corner of the planet” via their satellite data and 3D technologies and solutions.
Innovation: Hypersonics, AI, machine learning and the metaverse
Despite a return to ground warfare in Ukraine, contractors continue to invest in research and development to position the United States for the future of defense. Hypersonics continue to be a focus; AI and machine learning capabilities are accelerating data-driven insights, and the metaverse is shaping up to be an enhanced source of training, gaming and simulation exercises.
Eric DeMarco, president and CEO of Kratos Defense and Security Solutions, emphasized the company’s continued investment in hypersonics, both domestically and in Australia. Meanwhile, Aslett touted Mercury’s outsized research and development investment, predicting the industry will follow suit.
Despite a return to ground warfare in Ukraine, contractors continue to invest in research and development to position the United States for the future of defense. Hypersonics continue to be a focus.
Jablonsky cited strong adoption of Maxar’s AI and machine learning capabilities by U.S. and international government customers and expressed excitement about the future of physics-based metaverses.
Finally, L3Harris and Maxar gave examples of strategic partnerships and venture capital equity investments in support of innovation.
Maxar made a data-for-equity investment in Blackshark, a company that will make products using Maxar’s data in exchange for royalties. L3Harris, meanwhile, partnered with Shield Capital, a venture capital firm that will provide L3Harris with access to new startup technology companies with commercial technologies that want to support the Department of Defense. L3Harris plans to invest in these companies to help them achieve that goal.
The takeaway
Executives in the sector continue to battle inflation and supply chain challenges like most participants in the economy. However, increased defense spending, both domestic and abroad, paired with continued demand for innovative technologies, are driving optimism.
Selling to international allies provides contractors additional cash flow needed to generate return on their heavy research and development investment. This will be of utmost importance as the defense industry seeks to keep up with the rapid pace of change in the digital economy and battlefield.
For more insights, read RSM’s government contracting industry oulook for summer 2022.
