Market Watch: Does defense transformation help or hurt industry?

Defense industry investors continue to assess the likely impact of defense transformation on the industry and individual defense contractors. A core aspect of transformation is rapid infusion of cutting edge technology. For many companies serving defense and homeland security markets, the opportunities have never been greater. But for others, including some long-established companies, substantial repositioning is essential for long-term success. Rapid technological advances and the changed threat environment are changing war-fighting strategies and military organizational structures. Political influences, inherent to funding and priority setting, may reduce the speed with which resources can be reallocated and facilities rationalized, but military transformation will occur. The key questions are: "How will it affect the industry and which companies will be winners?" In my view, the number of companies with solid growth potential far outnumbers those facing difficulty and decline.Here are the themes relating to defense transformation.First, change takes time. Even allowing for joint initiatives among its branches, the Defense Department remains balkanized in many ways. Military platforms and thousands of legacy systems remain in place. Incumbent relationships have deep roots. In-place contractors and their legacy technologies, together with their supporters on the government procurement side, naturally resist rapid change. Similarly, closing military facilities and re-directing funds from obsolete systems to new technology is often a no brainer -- except to those citizens and employees directly involved. Second, emerging or disruptive technologies create a dilemma for government procurement officials and defense contractors. Both have invested a lot of time and money in developing and deploying existing technology. The contractor usually has anticipated a continuing production run for initial units and spares (or upgrades). Often, because the new technology is faster, smaller, more powerful and cheaper, the contractor will earn less revenue from the disruptive replacement.On the government side, a procurement official who has just spent several million dollars to develop a solution might not be pleased to encounter new technology with superior capability at a fraction of the cost.Third, rapid technology development is continuing. The number of technology companies pursuing defense and homeland security markets is growing. Federal funding through the Small Business Innovation Research program is producing productive hardware and software, while commercially developed products are increasingly integrated into defense systems. Information security, imaging, biometrics, optics, sensors and laser technology, among others, are revolutionizing our defense strategies and tactics. Nanotechnology portends systems and components too small to see. Threats can be addressed differently, with less human risk and involvement. Processing and transmission capacities dwarf even recent levels. These disruptive technologies will allow the Pentagon to do more with less investment. Finally, quality companies from tier-one prime contractors to small start-ups are capitalizing on the opportunities that transformation and technology change present. Small companies with strong R&D capabilities are creating a large portion of disruptive technology.Large prime contractors have moved aggressively into IT, software and technical services, acquiring smaller businesses with distinguished technologies. For the small to mid-sized defense company, this environment presents many opportunities to grow with the deployment of new hardware, software and services. For larger legacy companies, the additional challenge is to reposition and reinvent while maintaining or growing revenues. Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.