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Posted: March 10, 2014
Hugo Trepant
Hugo Trepant

Hugo Trepant  is a Strategy& partner based in London. His focus is on the aerospace, defense, and security industries, working with clients in both the commercial and public sectors.

 

Diane Shaw

Diane Shaw is a principal with Strategy&. She has significant experience in defense and security in the public sector.

 


 
 

How Defense Companies Can Gain an Advantage in 2014

After more than a decade of war, and the heavy spending that came with it, new circumstances are radically transforming the European Union and United Kingdom’s defense industries. A combination of factors—including budget cuts by governments across Europe, sequestration in the United States, the winding down of Western involvement in Afghanistan, and the continually changing nature of warfare—are leaving many companies with massive overcapacity and cost structures no longer suitable to the realities of global demand and competition.

The news is not universally bad. Many defense companies saw their stock prices climb in 2013, several European countries have approved new shipbuilding projects and essential high-technology enhancements to fighter aircraft, and many governments are taking a keen interest in supporting their defense industrial capabilities.

But on balance, the industry faces significant headwinds, and dramatic changes are coming. If there’s any consolation, it’s that the industry has been through downturns before and can look to those episodes for lessons on how to deal with today’s problems. In fact, a look to the past may prove critical: Less than half of the companies that entered the last downturn in the 1990s survived, and only a small subset emerged with an improved market position that increased shareholder value.

In the 1990s, hunkering down and doing nothing did not work. And that lesson is equally true today. Countries tend to favor and protect their own defense industries, which means domestic companies can operate relatively inefficiently when budgets are robust. But when national defense budgets get cut and domestic companies are forced to compete on the global stage without a home-court advantage, inefficiencies are painfully exposed.

In the past, defense companies have reacted to shrinking markets by diversifying their portfolios in whatever direction they thought would generate revenue fastest. But this strategy tends to yield a portfolio of businesses that are not well aligned, creating a new set of deleterious inefficiencies. Instead of this ad-hoc approach to growth, we recommend a more strategically coherent capabilities-driven strategy (CDS) for long-term success.

CDS aligns a company’s differentiating capabilities (those things it does best) with its value proposition (its portfolio of products and services), and defines an efficient, flexible operating model. It also provides a useful framework to determine which parts of the business can safely be scaled back when revenues decrease, and which require continued spending even when revenues stagnate or fall. Our research shows that only with a CDS can companies reliably and sustainably outpace competitors.

In Europe, this focus on capabilities is becoming critical. The markets for tactical communications, transport and trainer aircraft, rotorcraft, tactical wheeled vehicles, and services have largely evolved to reward companies with the capabilities to compete on the basis of global scale and scope, or that have the capabilities to easily tailor solutions across defense and commercial markets. An original equipment manufacturer (OEM), for example, decided to use its inherent expertise in design to build a comprehensive information-led capability to offer more efficient support for its product around the globe, displacing low-cost service providers.

Unfortunately, many legacy defense companies have been slow to rethink their operations in these terms. As a result, their share of the large market of post–Cold War platforms and systems has shrunk from approximately 90 percent to less than 70 percent. And in the services market, their share has shrunk by half.
Once a company has identified its essential capabilities and how it wants to play in the market, it must build a cost-efficient operating model to leverage those capabilities over the long term, even as business circumstances change. The reality is that government defense budgets are shrinking significantly. While many defense companies have taken actions to reduce costs, many more cuts are necessary. Massive overcapacity and overspending is still endemic.

Yet cost cutting alone is not a winning strategy , nor is cutting across the board. Indiscriminate cutting can often leave a company weaker, not just smaller, by affecting areas with the greatest growth potential. In other words, companies need a strategic approach to costs. We recommend developing a Fit for Growth* approach that explicitly links strategy, the company’s growth agenda, budget cuts and investments, and corporate organizational structure. The goal is to redirect costs from low productivity areas of the business and invest in capabilities that align with the growth strategy, and establish an operating model to leverage those capabilities over the long term. Companies that do this well can create shareholder value through the downturn, and capture even more market share when the industry ultimately rebounds.

Cost cutting alone is not a winning strategy.

In the coming years, many of today’s defense companies will cease to exist. But others will emerge from the downturn better than before, and new companies will enter the market. By focusing on a capabilities-driven strategy and developing a Fit for Growth approach, defense industry executives can position their companies to become stronger and more competitive.

*Fit for Growth is a registered service mark of Booz & Company Inc. in the United States.

 

 
 
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