"Gentlemen, we have run out of money. Now we have to think."
-- Winston Churchill
Captain Henry (Jerry) Hendrix (U.S. Navy, retired) worries about America.
He worries about the state of the military, and worries about the national debt -- now topping $18.1 trillion. Generally speaking, he worries that unless we raise more revenue, and spend less money -- including on the military -- we'll soon go broke.
But there's good news, too. In "Avoiding Trivia," his latest paper for the Center for a New American Security, Capt. Hendrix argues that America's fiscal crisis is far from unique in our history -- and not insurmountable. And as a historian, as the former Tactical Action Officer aboard the aircraft carrier USS Theodore Roosevelt (CVN 71), and as the U.S. Navy's Director of Naval History, Capt. Hendrix has built up a commanding knowledge of U.S. military needs, both past and present.
Hendrix makes a strong case for America needing to redouble efforts to pay down debt, invest in infrastructure, cut defense spending, and avoid "trivial" foreign entanglements -- all while expanding its military presence to quell conflicts around the globe. If that sounds like a paradox, well, it is... and it isn't.
Capt. Hendrix notes that across the military today, planning (and spending) continues to focus on wars that the Pentagon wants to fight, rather than the missions that it will need to perform -- and in fact, is performing already, and has been performing for years.
The U.S. Marine Corps, for example, originally created to perform amphibious assaults in the service of the Navy, has morphed into a second land army. The Army itself, which has been performing counterinsurgency and nation-building work for the past decade, continues to stock thousands of Abrams main battle tanks designed to fight a holding action at Germany's Fulda Gap.
And the Air Force, whose most important function over the past decade has been providing close-air support for the Army and USMC in Iraq and Afghanistan, is trying to divest perhaps its most powerful CAS platform, the A-10 Warthog. Instead, the Air Force wants to buy F-35 stealth fighter jets from Lockheed Martin (NYSE:LMT), to win an air superiority battle against a "fifth-generation" foe that doesn't exist.
In his home service, too, Capt. Hendrix points out that Navy has spent the better part of a decade flinging Tomahawk missiles at land targets, and flying ground support missions off aircraft carriers. But rather than tailoring its force to perform these missions better, and cheaper, Harris says, leadership is sinking money into aircraft carriers like the new $14 billion Ford-class supercarrier -- designed to win a conventional naval war against a strong adversary who also doesn't exist.
For the same $14 billion, Hendrix points out, we could build a Nimitz-class aircraft carrier and three Arleigh Burke-class destroyers, or a Nimitz and 14 frigates. Or a Nimitz and 28 modular Joint High Speed Vessels. Or a combination of all the above -- a carrier, a destroyer, six frigates, and 10 JHSVs.
Such a "balanced" mix of forces, he warns, is necessary if the U.S. Navy is to return to a 350-ship fleet. And analogous mixes should be applied across the military services -- buying more F-16s, and fewer F-35s for the Air Force, for example. Purchasing more missiles and robots, and fewer tanks for the Army. Balancing a core force of high-tech, high-cost weapons systems against a wider array of cheaper systems already in mass production, we can build a military big enough to maintain a global "presence" -- and quell isolated outbreaks before they turn into all-out war.
What it means to investors
The problem, summarizes Hendrix, is that as the Pentagon's favorite weapons get higher-tech, they also get more expensive -- so we can't afford as many of them. That's the real cause of the "hollowing out" of the military, and why it's shrinking, pulling back, and unable to maintain presence around the globe as it used to.
And this is dangerous. Hendrix calls the absence of visible U.S. forces in an area a "precursor" for conflict. He sees the military's most important role not necessarily as fighting wars, but preventing wars from breaking out by patrolling, conducting training exercises with allies, and generally "showing the flag" to deter aggressors. While high-cost, high-ability warships are certainly desirable, it's more important to be in the right place at the right time to nip problems in the bud -- and that requires numbers.
But here's what investors must remember: All of this won't necessarily be bad news for defense contractors. If you think about it, Lockheed Martin has averaged operating profit margins of 8.4% over the past two decades. Lockheed can continue to earn those profit margins whether we ask it to build $1 billion worth of F-16s or $1 billion worth of F-35s.
The same holds true for other contractors. Huntington Ingalls (NYSE:HII) and General Dynamics (NYSE:GD) do good business building aircraft carriers and submarines for the Navy. But they can make just as much money building dozens of frigates and destroyers.
What's more, even if we do spend less on the military, lower revenues don't spell doomsday for defense stock investors. Lockheed's profit margin peaked at 11.5% in 2008, at the height of the Iraq war. But after two years of sequester-induced declining revenues, Lockheed's profit margin peaked again in 2015 -- at 11.8%.
The upshot: What America's military needs isn't necessarily more money. What we really need is just more... military.