Arming the United States is no longer the business it once was. The latest U.S. defense budget designates $170 billion for procurement and $145 billion for research and development (R&D), a significant portion of which flows to a select few “prime” contractors that directly engage with the Department of Defense (DoD). Some of the $44 billion in American military aid to Ukraine and a portion of the additional defense spending by America’s European allies, accounting for 5-10% of the primes’ sales, also contribute to their revenues. While these sums don’t increase as rapidly as corporate IT expenditures, arms manufacturers are shielded from catastrophic losses by long-term, massive contracts.
Due to a major overhaul at the end of the Cold War, the industry has become highly consolidated. In a meeting back in 1993, known as the “last supper,” William Perry, then Deputy Defense Secretary under President Bill Clinton, conveyed that excess capacity was no longer sustainable, and consolidation was essential. As a result, the number of primes has dwindled from over 50 in 1950s America to just six. The count of satellite suppliers has reduced from eight to four, fixed-wing aircraft from eight to three, and tactical missiles from 13 to three.
This concentration and the absence of intense competition have enabled American arms makers’ shares to consistently outperform the broader stock market over the past five decades. According to a Department of Defense paper published in April, between 2000 and 2019, defense contractors outperformed civilian counterparts in terms of shareholder returns, return on assets, and return on equity, among other financial metrics. A more unstable world translates into increased military spending and benefits suppliers. Total shareholder returns, including dividends, for prime contractors like General Dynamics, Lockheed Martin, and Northrop Grumman rose during Russia’s invasion of Ukraine in February 2022 and when Hamas attacked Israel on October 7th.
This cozy oligopoly is now encountering challenges on two fronts. One challenge is technological. As evidenced by tank battles in Ukrainian plains and Gaza’s streets, traditional heavy equipment remains relevant, as do missiles, artillery shells, and fighter jets. However, modern warfare increasingly relies on smaller, more straightforward tactical equipment, as well as communications, sensors, software, and data. The second challenge arises from the Pentagon’s quest to achieve better value for money from the military-industrial complex.
Both these developments undermine the prime contractors’ significant competitive advantages: their capacity to produce large equipment and navigate the complex procurement process. Cost-effective innovations, like the Pentagon’s “Replicator” project, which aims to swiftly deploy swarms of small drones, necessitate agile engineering, a capability not inherently present in the defense giants, as described by the consultancy Kearney. To thrive in this new era, they must rekindle some of the innovative approaches that played a role in shaping Silicon Valley in the decades following World War II. However, they appear to be encountering difficulties in doing so.
The existing setup favored by the prime contractors and their investors is understandable. The DoD reimburses the primes’ R&D expenses and adds an additional 10-15%. This “cost-plus” approach spares the companies from committing significant capital to risky projects, ensuring security but diminishing incentives for timely and on-budget delivery. For instance, the F-35 fighter jet project, which has contributed more than a quarter of Lockheed’s revenues in the last three years, began in the 1990s. It is running roughly a decade behind schedule and will cost American taxpayers up to $2 trillion over the aircraft’s lifespan.
Once large-scale newly developed equipment enters production, it is sold at a fixed price, often for decades. Northrop Grumman’s B-21 stealth bomber, currently under development, will cost the Pentagon more than $200 billion for 100 planes delivered over 30 years. The Columbia Class nuclear-submarine program, managed by a General Dynamics subsidiary, is scheduled to be operational from the early 2030s until at least 2085.
The Pentagon’s patience with this conventional business model is wearing thin. Last year’s national defense strategy succinctly stated it was “too slow and too focused on acquiring systems not designed to address the most critical challenges we now face.” Instead, it seeks to “reward rapid experimentation, acquisition, and fielding.” This shift compels prime contractors to explore ways to enhance their existing platforms by introducing new software, modules, payloads, and more, while establishing adaptable production processes.
For instance, Lockheed Martin’s CEO, Jim Taiclet, recently acknowledged that soldiers now expect seamless integration of sensors, weapons, and systems for battle management, such as the Joint All-Domain Command and Control (JADC2), a novel concept for data sharing across platforms, services, and theaters. The task of contracting, developing, and continually updating such systems poses a challenge for companies accustomed to producing substantial hardware slowly, and as Steve Grundman from the Atlantic Council’s think-tank explains, are not “digital natives.”
The prime contractors also face another dilemma. The technology envisioned by the Pentagon is not inherently military, as noted by Mikhail Grinberg from Renaissance Strategic Advisors, a consultancy. While most defense giants maintain civilian divisions, some quite sizable, such as Boeing, General Dynamics, and Raytheon, the Pentagon’s growing interest in dual-use technologies exposes them to competition from the civilian industry. This industry continually develops new equipment, materials, manufacturing processes, and software suitable for both military and civilian purposes.
In 2020, General Motors secured a contract to supply infantry vehicles, and it has now partnered with the American branch of Rheinmetall, a German weapons manufacturer, to provide military trucks. Other contenders are striving to penetrate the military-industrial complex, drawn by the DoD’s interest in more diverse systems. Palantir, founded in 2003 to help prevent further attacks like those on September 11th, 2001, produces civilian and military software for processing the vast amounts of data generated by modern life and warfare. Elon Musk’s SpaceX launches payloads into orbit, including military ones, and is paid by the DoD to provide internet access to Ukrainian forces battling Russian invaders.
Even major tech companies are entering the scene. Amazon, Google, and Microsoft view defense and security as promising markets, according to Mr. Grundman. Military procurement is one of the rare industries that can significantly impact these tech titans’ top lines, which often reach hundreds of billions of dollars. This trio, along with the smaller business software maker Oracle, are already collaborating on a $9 billion cloud-computing contract with the Pentagon. Microsoft also supplies the army with augmented-reality goggles, a deal that could eventually reach $22 billion.
The Pentagon’s evolving approach is also attracting emerging competitors. For example, Anduril, a company founded in 2017 solely to address military needs, has developed Lattice, a versatile software platform that can be rapidly updated and adapted to address new challenges. The company also produces a short-range drone called the Ghost, which can be operated by a small team of soldiers. Recognizing that fast business wins require vertical integration, Anduril acquired a rocket engine manufacturer and is developing an underwater autonomous vessel for the Australian navy.
