Most defense company executive teams are spending a lot of sleepless nights these days. Their worry: how to create shareholder value in a market with a gloomy long-term outlook. Defense and security budgets are heading south. “Sequestration” looms large on Capitol Hill. New program starts are few and far between. Internally, most companies’ cost structures are bloated from a 10-year growth cycle, and organizational complexity is rampant.
With that backdrop, how does a defense contractor make itself an attractive investment for shareholders? So far, we see A&D companies undertaking familiar strategies. They are reducing costs by streamlining their organizations. They are acquiring more companies in hopes of strengthening core businesses, filling capability gaps or gaining access to new customers. They are pursuing adjacent markets by chasing international contracts and new end markets such as health care.
These strategies can create significant value if executed well, but each has limitations. Then there is another, newer strategy: business model innovation. This involves developing innovative offerings or delivery models to meet customers’ needs at less expense—an urgent objective, given the government’s struggles to achieve its diverse objectives with fewer dollars. So far, we have seen four primary types of business model innovations emerge:
- Managed services. Providing a product or offering based on customer usage, allowing the government to avoid owning the asset. Example: the power-by-the- hour model used by engine OEMs.
- Commercialized offerings. Investing internal capital to develop an offering that can be sold off-the-shelf, such as Harris Corp.’s radio business.
- Exploiting “hidden assets.” Finding untapped capabilities to create alternatives—an MRO services company uses its internal demand-forecasting tools to provide other companies’ spare parts more rapidly.
- Creative partnering. Looking outside the industry to non-traditional sources of innovation. Consider Raytheon’s adaptation of Google’s Android platform as an experimental battlefield handheld device for soldiers.
So why are we not seeing more business model innovations take hold? Part of the reason is that launching one is not a natural act for most defense contractors. Managers are often conservative, more accustomed to decades-old standards for competing on new business—standards that are no longer affordable.
The business model successes we have studied or helped to implement all required significant change in business processes, management talent, capital allocation and governance. They often relied on a great deal of collaboration with trusted customers, because there were always hiccups along the way.
But contractor reticence is not the main challenge. The biggest barrier: government. At a time when the customer should be encouraging innovation, it is loading on new requirements, more auditing and tighter rules around competitions.
This should be a time when the government defines its most important mission needs and then asks contractors to provide innovative ideas. Let the contractors take on some of the inherent risk associated with business model innovation and reap the rewards if they deliver. For instance, if L-3 Communications can rapidly meet an airborne intelligence, surveillance and reconnaissance need using surplus aircraft, its shareholders should be rewarded. Of course, certain defense systems will not and should not ever be candidates for anything but the strictest developmental specifications and process standards. But that leaves a lot of room for innovation.
The path to more successful business model innovations mostly involves a change in mindset. Start with trust: Pursue market areas where suppliers and customers have an established business history and where joint interdependence exists. Take a few calculated risks. The government should encourage less of an audit-based culture. Contractors should find a few more uses for cash other than share buybacks. And think of it as talent development: At a time when both government and contractors are at risk of losing talent, deploying high-potential people to new business models is a great way to retain them.
Contractors need new avenues of growth, and the government needs a healthy industrial base. They both agree on the importance of partnering to find creative ways to fill unmet needs. What would happen if they opened up the aperture and let some new business models see the light of day?
Michael Goldberg leads Bain & Co.’s global aerospace and defense practice.