China has an aircraft carrier. ISIS has tanks. And over in Russia, it seems they've started invading countries again. It's a dangerous world out there, folks.
And yet, in a world where threats keep evolving, America's generals are beginning to wonder if defense contractors can keep innovating to keep pace with the threats. According to a recent article in The Wall Street Journal, they're criticizing defense contractors for coasting on big-budget defense programs "that can anchor jobs in their districts for years," and for spending too much cash on stock buybacks and dividend payments -- and not enough on the cutting-edge R&D work needed to innovate to keep America safe and keep costs affordable.
Blasting the industry for its failure to innovate, Defense Secretary Chuck Hagel recently called upon defense contractors to innovate more in the area of military robots and drones, focus improvements on easily upgraded software rather than hardware that can take years to come to market, and make use of 3D printing to speed up the process.
Instead, says the Pentagon, defense contractors today spend just 2% of their revenues, on average, on research and development -- just half what they were investing in R&D six years ago.
What the generals want...
The Pentagon is not wrong. According to financial data site S&P Capital IQ, for example, most big defense companies don't even break out R&D spending as a separate line item in their financial reports -- and maybe for good reason, if the aim is to keep you from seeing what's going on.
If you dig deep into the data, though, SEC filings show that Lockheed Martin (LMT -0.20%) -- America's biggest pure-play defense contracting company -- spent $697 million on "independent research and development costs" in 2013. That was up 19% from 2011 levels, granted. But it was down by 42% from the $1.2 billion that Lockheed spent on R&D in 2007.
Boeing (BA -0.03%), Lockheed's archrival in aerospace, spent $3.1 billion last year versus $3.9 billion in 2007. That was a 21% drop in R&D spending, despite the fact that Boeing was investing heavily in the development and fixing of its new 787 Dreamliner during that period.
The same is true elsewhere in the industry. Northrop Grumman (NOC 0.16%) spent $507 million last year, down from $537 million in 2007. General Dynamics (GD 1.12%) invested $310 million in R&D in 2013. In 2007, GD spent $622 million -- making today's spending a more than 50% decline.
What the generals say they want...
Result: According to the Journal, Former Deputy Defense Secretary Bill Lynn -- now CEO of the U.S. arm of Italian arms maker Finmeccanica -- says that these days, "more and more of the [best] technology is coming from outside the defense industry." What he doesn't mention is that there's a lot of fine technology coming from inside the defense industry, too. It's just not being produced by what we think of as "traditional" defense contractors -- such multibillion-dollar-market-capped, publicly traded behemoths as Lockheed, Northrop... and Finmeccanica.
Take a look at the "tank" up above, for example. It's the Ripsaw MS-1 unmanned ground vehicle built by privately held Howe & Howe Technologies. Built out of steel alloy tubes, the remotely controlled Ripsaw weighs less than five tons, can run at speeds of 65 mph -- and can accelerate from zero to 65 in just three seconds.
Lacking armor plating, it's not a "true" tank like General Dynamics' M1 Abrams main battle tank. But the Ripsaw can carry anything from M240 machine guns to M2 .50-cals to Javelin missiles -- it still packs a punch. And priced at just $200,000 a unit, Ripsaw costs the merest fraction of the $4.3 million price tag on an M-1.
Or consider this little beauty:
This is the Ghost, a high-speed attack patrol boat that its maker, privately held Juliet Marine, calls the "attack helicopter of the sea." Ghost can race across the waves at speeds up to 50 knots, carrying a massive arsenal of up to 90 Nemesis anti-ship missiles -- and all for a retail price of just $10 million. At that price, you could build a 350-ship navy of Ghost boats for the cost of just one $3.5 billion Zumwalt-class destroyer.
Or this one:
This is the ultra-heavy-lift amphibious connector, a new type of amphibious assault vehicle built by privately held Navatek, and currently being vetted -- albeit at prototype, half-scale size -- by the U.S. Marine Corps. Media reports describe the new vessel as designed to replace and improve upon existing USMC hovercraft -- known as "LCACs" -- and being capable of paddling from sea to shore, then crossing onto land uninterrupted, trundling forward on a tread made of air-filled foam treads -- that are nonetheless sturdy enough to support the weight of a cargo of three full-size battle tanks (or who knows how many Ripsaws).
UHAC's projected cost? About half of what an LCAC costs, despite it having three times the payload.
...and what the generals actually get
These are the kinds of innovative weapons systems -- built outside the traditional defense industry, often the glorified garages of private entrepreneurs, and on shoestring budgets -- that the Pentagon seems to be asking for. But what do they have in common?
They're all cheap, no-frills weapons systems built with a specific mission in mind, built quickly, and with designs that can be tweaked on short notice, as circumstances require.
What else do they have in common?
To date, the Pentagon hasn't placed orders to buy any of them, instead awarding billions and billions of dollars' worth of contracts to buy F-35 stealth fighter jets that "can't turn, can't climb, can't run," littoral combat ships that lack "survivability," and M1 battle tanks that the Army itself says it doesn't need.
The upshot for investors
The Pentagon needs to match words with actions -- and dollars -- and change its shopping patterns to support innovative weapons designs, rather than funding jobs programs for Congress' favorite constituents. Until that happens, I'd say that the stock buybacks, dividend checks, and other largesse that investors in the defense industry have come to expect will remain safe and sound.