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Autonomy, the Army, and Investors

By Lou Whiteman – Sep 17, 2019 at 12:35PM

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Autonomy is changing the defense industry in a big way, and investors shouldn’t be caught off guard by it.

The military is often on the cutting edge of technology, and AI and autonomy are no exception. In this week's episode of Industry Focus: Energy, host Nick Sciple talks with Motley Fool contributor and defense industry follower Lou Whiteman about how new technology is changing the industry and what investors should know before buying in. Tune in to learn what companies are pushing this tech forward and which are at risk of getting left behind, what kinds of technology the army and navy are focusing on, how ethics discussions will shape the space in the short and long term, how close we are to fully autonomous weapons, and more.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on Sept. 12, 2019.

Nick Sciple: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, Sept. 12, and we're talking about the defense industry. I'm your host, Nick Sciple, and today I'm joined by Motley Fool contributor Lou Whiteman via Skype. How's it going, Lou? 

Lou Whiteman: I'm doing good! How are you doing? 

Sciple: I'm doing well! It's been a while since we've had you on the show. A lot of things going on. Always a lot of things going on in the stock market these days. One tweet can send the market up or down. But we have seen some signs of some slowing, particularly in the industrial market over the past year and a half or so. Auto sales in China have been in decline for 14 of the past 15 months, which has caused some trickle down issues in Germany, seeing slowing capital investment in the U.S. in machinery and trade due to the trade war and the slowing economy. And then we're layering this WeWork IPO, maybe failed IPO, on top of this. What have you been following in the market most closely these past few months?

Whiteman: As you said, we've seen warning signs internationally in the industrials for a while now. It is starting to creep into the United States. A lot of these industrials, they are selling big ticket goods, goods that need to be planned. As uncertainty grows, you see at least a slowdown. I think that's what we're facing. If you look back at second quarter earnings all across the board, largely the companies did pretty well, but the guidance was the issue. And what that is is, whether or not this materializes as a slowdown remains to be seen, but with the trade uncertainty, with so much going on domestically right now, it's really hard to plan, and that usually leads to a slowdown. I think that's the worrisome sign right now, at least domestically.

Sciple: Yeah. Steel producers are one example of an industry that seems to have been caught off guard. You had a year or so ago, folks talking about really ramping up production, and now you've got the idea of maybe cutting production. A lot of uncertainty right now when it comes to what the industrial markets are going to look like going forward, as you mentioned. Do you have a bold prediction of what we might see coming up? Obviously, hard to predict.

Whiteman: Let's go deeper. It's a fool's errand to try and predict a recession, but old people like me are seeing a lot of things that at least rhyme with the end of cycles. A lot of activist activity, a lot of corporate splits. Usually, you see these industrial companies, they start splitting up when they're running out of growth. It's plan B when you can't produce top line, bottom line growth. I hate to call it. Maybe we'll go on for a couple of more years. But I wouldn't be surprised if we're talking in September of next year, trying to gauge how deep the slowdown will go, and not how much more the bull market can go. But, who knows? Bold prediction. We're talking about slowing industrials. These are businesses with steady cash flow, easy to understand. Just the sort of thing that Warren Buffett and his $120 billion in cash loves to find. He's complained about valuations. If we're right, then we might see valuations coming down. I really think we're going to see Berkshire put money to work in a big way before the end of the year. I think maybe in the industrials. I'd hate to pick a company. For my money, the best deal he's ever done was the Precision Castparts deal, the aerospace deal he did. That was just a terrific company. I wonder if he may go back there, something like a Stanley Black & Decker or maybe another industrial. One well-known in Fooldom, Middleby. I think Warren Buffett's going to do something big. I think it might be an industrial company because I think some of the valuations are coming back to him. And I think he's itching to do something. So, there you go.

Sciple: Yeah, I think that's a great pick. Like you, I'm not super comfortable running rushing out here and predicting a recession or anything like that. But I will say, with interest rates continuing to fall, and valuations appearing to come down, I think companies like Brookfield Asset Management, [Berkshire Hathaway], these types of companies that have permanent capital on hand to invest when prices become attractive, and that have a track record of squeezing out cash flows from these businesses, they're going to be really attractively placed as we move into the next year and a half or so. We'll see. 

Whiteman: We'll see. 

Sciple: There's always some level of uncertainty here in the market, particularly these days. 

Whiteman: We've just guaranteed a huge upsurge over the next few months, right?

Sciple: 100%. [laughs] OK, let's move on to our main topic today. I maybe undersold it off the top of the show. I said we're going to talk about the defense industry. But we're talking about terminators, Lou. We're talking about fully autonomous weapons. Can you give us an overview of where we're at as far as the early stages of this industry, and how we got here?

Whiteman: Sure, sure. Drones are well known. We've been using drones -- I think the first use of drones in combat was February 2002 in Afghanistan. It goes back further. The Navy was actually experimenting with what they called air torpedoes back in World War One. The military, especially the Air Force over the last almost two decades, has been growing increasingly comfortable with drones that take on special missions, very specific missions, and usually with a controller back somewhere with a joystick, not far away. These are used largely for reconnaissance. We've seen, in recent years, a lot of them are shooting vessels. It's unmanned, so we're moving in that direction, but it isn't really the stuff of Terminator. The next step is to get toward some of this stuff of science fiction. We're not there yet, but we're getting a lot closer than I think people realize.

Sciple: Right. The latest cutting edge defense programs around this is called Loyal Wingman programs, these Loyal Wingman drones. Lou, can you tell us, what are these aircrafts and what are they designed to do?

Whiteman: Imagine going into battle with an F-35 alongside a smaller version of the F-35, almost. Without a pilot. Believe it or not, the Pentagon is budget conscious, despite all the money they spend. They're trying to get the most bang for their buck. And the idea, if you could put four or five autonomous drones, or at least semi-autonomous drones, with firepower -- it's extra firepower, it's basically extra missile capacity for any of these F-35s. Also, even what the F-35's stealth technology, missile defense and defense against airplanes is getting more sophisticated. There's a hope if you can throw one plane and 20 drones at a system, you can confuse a system, you can overwhelm the system and actually help ensure the safety of the piloted aircraft. 

These are systems that work in tandem with a piloted aircraft. They're moving toward AI. It's really impressive, the things they can do on their own. It's not quite that you're sending a plane out on their own, but it's a huge step from the drones that are just piloted by joystick back 100 miles away. It's really interesting how close we are.

Sciple: Are these wingman drones controlled by the fighter pilot that's traveling with the drones? Or are they controlled back home? Are they controlled on their own? How do these all talk to each other and work together?

Whiteman: Right now, the key is, they work together. It's all working in tandem. Part of this process is writing the software and figuring out exactly what they will do. We're still in the proof of concept. The idea of it would be, they are programmed from afar and reacting on the fly with the fighter plane. It's kind of fuzzy right now. They're not just going to be sent off on their own to find a target and kill it. They are going to have some pre-mission download. The way the AI comes in is to be able to react in real time with the plane, with whoever they're accompanying, and deal with threats as they come up.

Sciple: Yeah, augment the firepower of the pilots themselves and those sorts of things. We probably have some major defense contractors in play here. Who are the main companies that are operating this Loyal Wingman space? How have they performed so far?

Whiteman: The big company is a new name for defense. It's been around a while. Kratos is the name of the company. This is a kind of odd company. Back in the day, they were a wireless infrastructure company. Over time, they used M&A to pivot to defense. They've been in a lot of different defense businesses, some more successful than others. They bought and sold, and they now have a core business. A lot of their revenue coming in is from what I call dumb drones. These are target practice drones that will just shoot up to give the Navy practice shooting missiles down. But they're jet powered, they're fast. They've used what they've learned with these drones to build the front runner in the Loyal Wingman concept, a plane that is actually being tested by the Air Force right now that looks really promising. So, they're big there. 

Their nearest competition would be Boeing,which, of course, is a very big name. Boeing, just in the last six months, has announced their own version of a wingman. They're doing it in Australia, which is going to be interesting because they're dealing with the Australians a little closer right now than the United States. There could be, maybe, some issues bringing that back into the United States. It does open Boeing up to export the plane a lot easier than a U.S.-based plane, so there's advantages there. Boeing is behind Kratos. If Kratos can do what they set out to do, they're going to get there first. 

AI is something that all of the big contractors are working on. You're only going to see more announcements.

Sciple: Just to illustrate, you talked about the cash savings from this program, a stat that you had called out to me is that this Valkyrie Loyal Wingman airplane that's being developed by Kratos would sell for around $2 million to $3 million vs. $80 million plus for an F-35. Obviously, a massively reduced bill when it comes to the military. How big could this market potentially be, Lou? Any idea how big the opportunity is for Kratos and others in this little Wingman program?

Whiteman: Sure. For now, we should emphasize the plus on that $80 million for the F-35. That's like the number the car dealer will give you when you come in to get a car. But, initially, we're talking, I think Kratos would like to see an order for 100 drones or something. Doesn't sound like a lot, but this is a company that had 2018 sales of just north of $600 million. It is needle-moving for them. Over time, I think the market could be a lot bigger. We're not going to replace the F-35, but I do believe that if this goes as planned, we are going to see these in the thousands and not in the hundreds with the Air Force. And in a relatively short amount of time, perhaps, if they work as planned.

Sciple: Which would obviously be incredible for keeping more people safe, augmenting. Fewer people that have to put themselves at risk when it comes to military combat. The Air Force has a lot of programs at work when it comes to drones, but they're not alone when it comes to development of autonomous programs. The Navy is also developing some undersea and chips that operate autonomously. Can you tell us a little bit about that, Lou?

Whiteman: Sure, sure. The Navy may be where the coolest stuff is going on right now. We're pretty accustomed to drones. The Navy has been watching what the Air Force has been able to do with drones with envy for a while now. In the battle for budgets, especially with what I do and watching the aerospace companies, I'm focused on the price tags for the equipment. Especially with these huge naval ships. A lot of the expense for the Navy is the personnel that goes into operating those ships. That is a real drag on the total spend for equipment they can buy, both because they have existing payroll to make, and they have to budget thousands of additional payrolls for every new ship they bring in for some of these bigger ships. The solution, at least in part, is autonomous or more autonomous ships. The Navy is making incredible progress there. Again, we're going to say the name Boeing -- they're working with Boeing on a large undersea vessel. Imagine basically a big sub. They call it the Orca. It's going to be a special use vessel. It's not going to replace our subs, but for reconnaissance, for patrolling areas, for monitoring the open sea, and with the size that they can put some sophisticated equipment there. That is coming. They're going to have very specific missions. They'll probably be monitored. I think that's a lot closer than people realize. 

On the surface, a company called Leidos, best known as a government IT company, they have been working with the Navy. They just sailed a ship from San Diego to Hawaii and back without intervention. That's a surface ship. It's a smaller ship for a warship. But, just to give some idea of some of the stuff that's being looked at right now. There's going to be a lot of opportunities for the contractors, both to build the boats and to build the brains of it. We're slowly seeing the evolution in the defense industry, from just being metal benders to being programmers and being systems integrators. As we know from other industries, that tends to be a higher-margin business. And we're just on the tip of the iceberg of some of this stuff. The Navy, autonomous is a great example of where you can see that.

Sciple: Sure. When it comes to these autonomous programs as well, we talk about reducing prices, and the idea that maybe we can reposition some of our spend to get more bang for our buck. As we see more upswing in autonomous programs with the Navy, are there any companies you think are at particular risk of maybe losing some business or losing some opportunities they may have had in the past?

Whiteman: There's two big ship builders. There's Huntington Ingalls, and that's all they do, so they are always at risk to changing trends in the Navy. And then General Dynamics has a very large naval business. They're both involved here. Huntington Ingalls is the contractor that's doing the metal bending for this Boeing owling Orca. There's revenue in there. Again, the worry is, you don't want to be the metal bender in a digital world. General Dynamics, we haven't mentioned it, but they have a huge autonomous program themselves. Just this week, they announced the Bluefin-12, which is a small torpedo-sized boat. So, they're all working on this. I wouldn't hit the panic button for now. Huntington Ingalls is our sole nuclear manufacturer for our carriers and our subs. The nuclear power plants, those aren't going away anytime soon, so the business isn't going to just evaporate. But I think we are at a point where we're seeing companies that you never thought of as hardware contractors slipping into the space. Boeing is only basically thought of as an airplane maker, using what they've learned with drones, underwater. There are shifts happening. There are subtle disruptions happening. And I think the metal benders, the Huntington Ingalls, the General Dynamics, they do have to be monitoring this and watching this. And I think they are, but there's still risk there.

Sciple: Yeah. It's one of these, technology touches every one of these industries, including military, maybe foremost. I mean, you talk about autonomous cars. The very early days of that began with military research programs. It's really important that it's cutting edge there. 

We've talked about the Air Force, we've talked about the Navy. There's also upcoming programs when it comes to the Army replacing the Shadow drone that was first introduced in 2001. What can you tell us about new development when it comes to drones for our Army?

Whiteman: You hit on it -- the Shadow, 2001. You can think of what's happened to your cellphone or your computer since then. This is a program that needs a refresh. The Army is working through it. Boeing was thought of as a favorite just because Boeing won a very similar marine contract. The Army appears to be going in another direction. Textron is the incumbent here. Textron is still in the race. They're going up against a small company that's partnered with Northrop Grumman, who's been another pioneer with drone systems. This is going to be a big contract. We don't quite know yet what the Army wants to buy. If it's a one-for-one replacement, we're talking about $2 billion in revenue. Again, for Textron and Company -- I think people should think of them more as a defense contractor. I don't know if people necessarily see it that way. This is a very intriguing thing. It can really be a needle-mover for them. 

This also speaks to -- a naval ship can go 50 years if it has to, and you can overhaul things. As we get more technological, as we're more cutting edge, we're going to see shorter replacement cycles, and hopefully more opportunities for these companies. Maybe not hopefully for the taxpayer, but hopefully for the companies.

Sciple: It is striking that a military program like the Shadow drone can have been around for 18 years without an update. How optimistic are you, given the current system of how budgeting works for the military and those sorts of things, that we can be more dynamic in updating these systems in a proactive way?

Whiteman: I think we actually do a decent job of it. It could be a lot better. But I think the Shadow has been a good performer. One of the reasons that it's taken so long, it has a lot of faults vs. current technology. It's big and cumbersome and loud. The replacement will be a worthy replacement. The Army gets this. Across the Pentagon -- I saw a quote not long ago, Rear Adm. Casey Moton saying, "We're buying rapidly here, we're moving fast, because we need to." It's never going to be fast enough, but a big portion of the Pentagon budget is R&D, is forward looking. That does go to the contractors and incentivizes them to be looking. 

18 years is a long time, but then again, this was a decent product, and we've had other priorities. I think the product cycles are going to get shorter. I think the development cycles and the procurement cycles need to get shorter. There's a lot of issues. There's a lot of politics there. I think that's something that is front of mind. I think it's something that'll slowly get better. But, maybe never good enough in all cases.

Sciple: One other thing from a policy point of view that I'd be remiss if we didn't discuss when it comes to automating our military is that ethical question of how far we want to go into allowing machines to make decisions to harm human beings without some kind of human intermediary. When it comes to the growth of automated military and the growth of this industry as a whole, how much of a modulation on that growth do you think these ethical issues will be over time?

Whiteman: It's a huge issue, without a doubt. Now, I think the best thought experiment on this -- it may have been something that you and I've talked about earlier in the summer, when we were talking about the nuclear triad. We are capable, we have the capabilities, to try to put satellites up in space that could detect a ballistic missile launch, read what it is, and take it out before it gets off the ground. We could do that today. The issue is, it would have to happen in a matter of seconds. It wouldn't happen with someone back in California telling it, "Yeah, you're right." What would happen if, for some reason, it sees a launch to the Space Station out of Central Russia as a missile headed for Washington, D.C., and starts World War Three? That is the risk of autonomous. It's a much smaller scale when you're talking about a Loyal Wingman drone and it might just take out a dozen people or something, not start World War Three, but it is every bit as real. And it is hard to imagine in the foreseeable future that we can solve that problem. We can work around that problem some. We can limit the use, we can have eyes in the air with an F-35 pilot. I think we'll even get to the point where some things -- like, if you can identify a tank in a in a hostile area, you shoot; or, maybe identify this tank vs. that tank. I think we can get part of the way there. But it's hard to imagine the sci-fi movie future where we're just sending our robots out to fight your robots. Even if the technology can get there, it's hard to imagine the ethics getting there in any reasonable amount of time. At least, let's hope.

Sciple: Yeah. If you think about it, we're 100 years on from World War One, where as a society, we had to make decisions on the rules we wanted warfare to be waged by. As we move 100 years into a new century, we've got autonomous warfare, we have to decide as a society, a global society, where we want to draw the line when it comes to military conflict. We've had the UN Secretary General come out and comment on this, saying, "Autonomous machines with the power and discretion to select targets and take lives without human involvement are politically unacceptable, morally repugnant and should be prohibited by international law." We've got, the Defense Department in the U.S. has been developing some ethical principles to guide how we use this technology. We've had in private industry, Google and other companies, their employees push back on working with the military. This is something we're going to continue to have to navigate going forward. When you're investing in this space, Lou, how do you think about these risks or these concerns in society, and how that may affect these businesses moving forward?

Whiteman: We're in such early days. I think there is an inevitability of AI coming into defense. As an investment, it doesn't worry me today. I think there is enough work to be done in areas -- less lethal, non-lethal, we'll see -- there's enough work to be done, reconnaissance, patrolling shipping lanes, the Wingman concept, even if you're only overriding air defense systems. We have 10, 20 years of growth and development and expansion of this, I think, before we elbow up against these issues. So, as an investor, it doesn't worry me. Maybe as a human and as a citizen...I mean, sitting there listening to you rattle off some of that, and thinking, "All it takes is one rogue state." There's certainly things to think about. But I do think there's a technological inevitability. And I think we're in early enough days that there's enough roles to fill that will be acceptable that for now, there's real runway for this, as an investor.

Sciple: Yeah. We'll just have to see how things play out. Obviously a lot of ethical issues around this, but it's clear that the military is heading toward a more autonomous future, fewer human beings involved in combat, more autonomy and we'll continue to follow that as it develops. Thanks for coming on, Lou!

Whiteman: Thanks! It's a pleasure to talk!

Sciple: As always, people on the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against the stocks discussed, so don't buy or sell anything based solely on what you hear. Thanks to Dan Boyd for his work behind the glass! For Lou Whiteman, I'm Nick Sciple. Thanks for listening and Fool on!

Lou Whiteman owns shares of Berkshire Hathaway (B shares) and General Dynamics. Nick Sciple has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Berkshire Hathaway (B shares), Brookfield Asset Management, and Middleby. The Motley Fool has the following options: long January 2021 $200 calls on Berkshire Hathaway (B shares) and short January 2021 $200 puts on Berkshire Hathaway (B shares). The Motley Fool recommends Textron. The Motley Fool has a disclosure policy.

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