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How COVID-19 Will Impact the Defense Industry

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How COVID-19 Will Impact the Defense Industry

Defense companies are among the many industries that must brace for a coronavirus shock.

How COVID-19 Will Impact the Defense Industry
Credit: U.S. Air Force photo by Tech. Sgt. Heather Redman

The world underestimated COVID-19, the disease caused by a novel strain of coronavirus that emerged in late 2019, in terms of both its propensity to spread and cause harm and its ability to bring businesses and whole economies to a halt. Many countries are in the midst of executing either mitigation or all-out suppression strategies that are taking a toll on both populace and industry.

The whiplash has been beneficial to some industries, such as retail FMCG (fast-moving consumer goods) and medical commerce, mainly because of unanticipated demand growth due to panic buying, while for some other sectors, such as hospitality and civil aviation, the pandemic has resulted in a grave downturn. It’s very important to note that while for some types of businesses the effect of the pandemic will be very pronounced in the short term, for others the effects may take more time to manifest. The latter is especially true for industries that are exposed to a large number of externalities – political, economic, and social. The defense industry falls into this category.

While it is too early to accurately predict whether the industry will be flat, take a major or minor dip, or grow unaffected by the global pandemic, it is of utmost importance that defense companies identify what the major impact points are and assess their potential to affect business development plans, supply chains, and bottom lines. This will help shape preemptive measures, which could help companies weather the storm.

Broadly speaking, the effects on the defense industry because of the spread of COVID-19 and related actions to curtail the contagion can the condensed into five major impact points:

  1. Production/manufacturing facilities and supply chains could be affected.
  2. Business development efforts could be affected – some will lose, some may win.
  3. Demand for defense equipment and related services could go down.
  4. Companies may have to make tough choices that could impact finances and competencies.
  5. Stock price declines will bring secondary effects.

The effects of each of the above major impact points will differ based on the size of defense companies, nature of business, product portfolios, supply chain dependencies, and business plans, just to name a few. As a result, a more granular analysis of these points is warranted.

Supply Side Shocks: Production, Manufacturing, and Supply Chain

Supply side shocks are perhaps some of the most visible effects of the pandemic’s impact on the defense sector. Companies that are located in countries badly affected by the virus or those that are dependent on supply chains located in affected countries are the immediate victims of the pandemic.

A case in point is Fincantieri of Italy, which has currently suspended its ship building operations until March 29, 2020. The company builds warships of complex design and is a major participant in Qatar’s naval expansion program. It is contracted to deliver four corvettes to the Qatari Navy. Though one of the ships was delivered earlier this year, other deliveries could be pushed back if the company extends the close down of its facilities – a probable course of action if Italy is not able to flatten its COVID-19 growth curve soon. If operations remain suspended for a protracted period of time, the company could potentially lose out on foreign opportunities at a time when naval modernization is gaining precedence. With COVID-19 cases on the rise in Western Europe, operations of many other defense firms in Europe, such as Navantia and Indra in Spain, for example, may be affected by partial or complete shutdowns or regulated functioning, thus affecting production queues and deliveries.

The nature of supply chain and resourcing patterns of the defense technology industry base (DTIB) will also affect production, as production queues with branched-out supply chains are more likely to face supply side constraints. The European DTIB has a fair share of branched-out supply chains, with different components and subsystems from different sources of origin going into a final platform or solution. Regulation and reprioritization of production functions of such supply chains could affect defense production. The plausibility of such actions cannot be ruled out, especially if governments divert facilities to manufacture medical equipment such as ventilators.

Technological factors and manufacturing paradigms also have a part to play in understanding the level of impact. For example, defense firms with highly automated plants are likely to be less affected by social distancing. Similarly, those companies that have not completely transitioned into certain manufacturing paradigms such as just-in-time production may have a greater level of inventory, and thus could be able to cope with supply side shocks for a longer period of time.

The Impact on Defense Business Development

Business development in defense is fairly different from that of many other industries, characterized by long negotiation periods, protracted engagements, high stakes, government-to government (G2G) linkages, extensive testing and evaluation, and face-to-face meetings. The current scenario does not bode well for business development in this industry. Note that many high value procurement programs are discussed and finalized during defense shows; with planned events such as EUROSATORY 2020 (scheduled for June in Paris) now uncertain, avenues for business development are reduced. Though meetings and discussions may continue to occur through teleconferencing, final decisions regarding high-value procurements are unlikely to be made through this method. Another point to note here is that unless a vaccine or cure is developed and administered, we cannot rule out potential resurgences of COVID-19 and associated cycles of mitigation or suppression measures that could derail business development.

Military exercises are another facet of indirect defense business development. These exercises expose operators and decision makers of prospective buyer nations to foreign equipment and their capabilities. Major powers such as the United States have already suspended all travel, deployments, and exercises for troops. If the pandemic worsens, wider cancellations or reschedulings cannot be ruled out, and as military forces in many cases are involved in attempting to reduce infection rates, the knock-on effect could exasperate the situation. Also, a cessation or reduction in military exercises will further reduce reduce the time for interaction and informal testing and evaluation of equipment, reducing an exercise’s latent business development potential — especially with the recent trend of using exercises to reduce procurement timelines.

Governments Deprioritizing Defense Spending and Procurement

Major defense spenders allocate close to or over 2 percent of their GDP, a significant amount, to defense. Whether defense spending may be deprioritized or not will depend on a number of other factors, both economic and societal. Countries badly affected by the pandemic will have to shore up their healthcare spending – capacity in hospitals may have to be expanded, new equipment will have to be bought and more services will have to be procured. The quantum of increased healthcare spending will in turn depend on other factors such as the existing state of healthcare, the mitigation or suppression strategies employed, and even the civic responsibility of citizens to counter the contagions. Countries that have really poor or inadequate healthcare infrastructure and penetration may need to spend a lot more to cope with the contagion than others that have strong healthcare.

It is likely that governments around the world will have to spend a lot more on social security. Also, governments may have to carry several businesses through low interest loan hand outs and interest subventions on existing loans. If governments are in questionable financial shape, with low liquidity, limited reserves, and inadequate avenues for borrowing, eventually the unanticipated spending will have to be met by channeling funds from other high-value budget components – defense included. While larger defense companies may have some contingency planning in place to wait out the worst-case scenario, local small and medium enterprises that run liquidity risks and have high levels of debt on their balance sheets may not fare too well. These companies will need bail outs or some form of monetary support to continue.

Tough Choices Ahead, Perhaps

While the defense industry is currently not affected as much as many other industries, we need to keep in mind that defense contracts are very high-value contracts and a potential loss of business due to a COVID-19 related worst-case scenario could mean that companies lose out on anticipated sales worth hundreds of millions of dollars. Companies may have to make tough decisions on how the business may be conducted in the future.

Maintaining all assembly lines and an active workforce in the face of reduced sales is a challenging situation defense companies could face. At this point businesses are faced with tough questions: Do they maintain the workforce level or trim it at the risk of losing capable people? Do they delay payments to vendors? Do they turn to governments for help? Do they divert R&D budgets toward paying salaries at the risk of losing technological edge? Do they relocate production sites? How will they maintain shareholder confidence? Defense companies must work on future-proofing themselves and must be prepared with answers to such questions in order to deal with the uncertainties stemming from shocks caused by the pandemic.

Secondary Effects Due to Stock Price Declines

A look at the stocks of defense companies that manifest visible shocks from the pandemic paints a worrying picture. From February 10 to date, Lockheed Martin’s stock price has fallen by around 28 percent, Leonardo’s by 55 percent, Thales’ by 33 percent, and Fincantieri’s by 32 percent. Shares of some defense companies are currently trading at their lowest prices in the past five years. While trading in secondary markets does not directly affect incomes of companies, we need to be wary about its indirect consequences. Companies that planned to issue shares in the primary market to fund capital investments may have to hold off as low share prices are detrimental to successful public offerings. Business expansion plans will have to be deferred. Another more worrying consequence of this could be a potential loss of control or a takeover if other entities buy out cheap shares. Defense companies may have to resort to share buybacks in order to prevent such events from happening, in turn resulting in more expenses and loss of liquidity for the firm, at a time when thriftiness is the need of the hour.

Possible Scenarios and the Way Forward

The discovery of a vaccine or cure for COVID-19 in a few months and successful containment during the downtime could leave the industry less affected. Some contracts, defense events, and business development measures may be pushed back but overall the defense sectors may just flat-line or even show slight growth because of pent up demand toward the end of the year. Setbacks may be just temporary.

However, if the discovery of a vaccine or cure takes a lot longer than expected and containment efforts in the downtime are only moderately successful, we may see defense spending deprioritized and supply side pressures causing defense companies to face tough decisions. There is no magic bullet for successfully weathering this scenario. Every company will have to make a different set of choices after carefully considering its financial conditions, the conditions in its target markets, the stress its supply chains are under, and many other factors.

A third scenario is also plausible in which a vaccine or cure is completely elusive, and we have to learn to cope with COVID-19 just as humanity has learned to cope with myriad other diseases. In such a scenario, it might be unviable to continue a suppression strategy indefinitely and governments and businesses will have to turn to mitigation. We will have to “live with the virus” but defense businesses have to be prepared for suppressive measures whenever there is resurgence.

Irrespective of how the COVID-19 scenario may turn out, there are some common lessons for the defense industry. Uncertainty in today’s world must be accepted as a norm and the defense industry must explore multiple facets of risk planning. Strategy should not just be focused on growth but must include scenario-based resource planning and material substitution. Manufacturing principles that advocated maximizing efficiency and reducing costs through maintaining minimal inventory may not factor in the uncertainties that abound today. Such textbook principles may have to be modified before application. Technological interventions to increase automation levels and using unmanned systems for resource/component/subsystem delivery could help reduce downtime during shocks. Coincidentally, these happen to be two segments that many defense companies have strong capabilities in – though from a product standpoint. The related technologies are maturing fast and some of these technologies may have to be refocused inward on company processes, not just on market-ready products and solutions being developed. Benjamin Disraeli’s practice of preparing for the worst, but hoping for the best seems to be good paradigm for defense companies to follow in these uncertain times.

Arjun Sreekumar is a Senior Consultant in the Aerospace, Defense, and Security team of a reputed global growth consulting company. He also leads the defense research teams in Europe and India. Views expressed here are personal and do not represent the views of the company