Coronavirus disease 2019 (COVID-19) is caused by the severe acute respiratory syndrome coronavirus 2 (SARS-CoV-2) and the world has underestimated it, both in terms of its propensity to spread and cause harm, and its ability to bring economies and businesses to a halt.
Many countries are in the midst of executing either mitigation or all-out suppression strategies that are taking a toll on its populace and industry. The fallout has been beneficial to some industries such as retail FMCG and medical commerce, mainly because of unanticipated demand growth due to panic buying; whilst for some others such as hospitality and civil aviation, the effects of the pandemic has resulted in a grave downturn. At this juncture, it’s very important to note that whilst for some types of businesses the effect of the pandemic will be very pronounced in the short term itself, for others the effects will take more time to manifest. The latter is especially true for industries that are exposed to a large number of externalities – political, economic, and social; the defence industry falls into this category. It is too early to accurately take a call on whether the market will be flat, take a major or minor dip, or continue to grow unaffected by the global pandemic. It is therefore of utmost importance for defence companies to identify what the major impact points are and assess their potentials in terms of affecting business development plans, supply chains, and bottom lines. This will inform necessary pre-emptive measures to help companies weather the storm.
Broadly speaking, the effects on the defence industry because of the spread of SARS COV-2 and related actions to curtail the contagion or fight the virus can be condensed into five major impact points:
- Production/ Manufacturing facilities and supply chains will be affected
- Business development, sales, and marketing activities – which are already heavily curtailed due to travel and social gathering restrictions.
- Budgets and demand for defence equipment and related services could go down
- Companies will have to make tough choices on product and service development that will impact future finances and competencies
- Secondary effects due to falling economies and stock markets
The effects of each of the above major impact points will differ based on the size of defence companies, nature of business, product portfolios, supply chain dependencies, and business plans, to name but a few. As a result, a more granular analysis of these points is warranted.
Supply Side Shocks – Production, Manufacturing and Supply Chain
Supply-side shocks are perhaps some of the most visible effects of the pandemic’s impact on the defence sector. Companies that are located in countries badly affected by the virus or those that are dependent on supply chains located in affected countries are the immediate victims of the pandemic, for example, Fincantieri of Italy has suspended all shipbuilding operations. The company builds warships of complex design and is a major participant in Qatar’s naval expansion programme and is contracted to deliver 4 corvettes to the Qatari Navy. Though one of the ships was delivered earlier this year, other deliveries could be pushed back if the company extends the close down of its facilities – a probable course of action if Italy is not able to flatten its “COVID-19 growth curve” soon. If operations remain suspended for a protracted period of time, the company will potentially lose out on foreign opportunities at a time when naval modernization is gaining precedence. With COVID-19 cases on the rise in Western Europe, operations of many other defence firms in Europe, such as Navantia and Indra in Spain for example, may also be affected with partial or complete shutdowns or regulated functioning in place, thus affecting production queues and deliveries.
The nature of supply chain and resourcing patterns of the Defence Technology Industry Base (DTIB) will also affect production, as production queues with branched out supply chains are more likely to face supply-side constraints. The European DTIB has a fair share of branched-out supply chains, with different components and subsystems from different sources of origin going into a final platform or capability solution. Regulation and reprioritization of production functions of such supply chains could affect defence production. The plausibility of such actions cannot be ruled out, especially if governments divert facilities to the manufacture of critical medical equipment such as ventilators.
Technological factors and manufacturing paradigms also have a part to play in understanding the level of impact. For example, defence firms with highly automated plants are likely less affected by social distancing. Similarly, those companies that have not completely transitioned into certain manufacturing paradigms such as just-in-time production will have a greater level of inventory and thus can cope with supply-side shocks for a longer period of time.
The Impact on Defence Business Development
Business development, occasionally a collective term for business communication, sales, and marketing activities in defence is fairly different from that of many other industries. It is characterised by long negotiation periods, protracted engagements, high stakes, Government-to-Government (G2G) linkages, extensive testing and evaluation, and many face to face meetings. The current COVID-19 scenario does not, therefore, bode well for business development in this industry. Note that many high-value procurement programs are discussed and finalised during defence shows with planned events such as EUROSATORY 2020 (scheduled for June in Paris) now uncertain, traditional avenues for business development are greatly reduced. Though meetings and discussions will continue to occur through teleconferencing, final decisions regarding high-value procurements are unlikely to be made through this method; there is a recognised need to look a person in the eye when closing a major business transaction. This reduced social engagement environment is expected to continue for a considerable time, especially if a vaccine or cure is not developed and administered soon. Even then, we cannot rule out potential resurgences and its associated cycles of mitigation or suppression measures that could derail again business development activities.
Military exercises are another facet of indirect defence business development. These exercises expose operators and decision-makers of prospective buyer nations to foreign equipment and their capabilities. Major powers such as the USA have already suspended all travel, deployments, and. If the pandemic worsens, wider cancellations or rescheduling cannot be ruled out, and as military forces are involved in many cases in attempting to reduce infection rates, the knock-on effect could exasperate the situation. Also, cessation or reduction in military exercises will further reduce the time for industry-military interaction, informal testing and evaluation of equipment, and reducing an exercise’s latent business development potential especially with the recent growth of using them to reduce procurement timelines.
Governments Deprioritising Defence Spending and Procurement
Major defence spender nations allocate close to or over 2% of their GDP, a significant amount, to defence. Whether defence spending will be deprioritised or not will depend on a number of other factors both economic and societal. Countries badly affected by the pandemic will most likely have to shore up their healthcare spendings such as expanding emergency hospital capacity, procuring new equipment and other services. The quantum of increased healthcare spending will, in turn, depend on other factors such as the existing national state of healthcare, mitigation or suppression strategies employed, and even the state’s ability to implement and enforce the roles and responsibilities of citizens to counter the contagions. Countries that have really poor or inadequate healthcare infrastructure and penetration will need to spend a lot more to cope with the current and future contagions than wealthier nations which have already invested in strong public healthcare.
It is also likely that the government will have to spend a more on social security, and free up the provision of cash, such as through ow interest loan handouts and interest subventions on existing loans. If governments are in questionable financial shape, with low liquidity, limited reserves and inadequate avenues for borrowing, eventually the unanticipated spending will have to be met by channelling funds from other high-value budget components – defence included. Whilst larger defence companies will have some contingency planning in place to wait out the worst-case scenario, local small and medium enterprises that run liquidity risks and have high levels of debt on their balance sheets may not fare too well. These companies will need bailouts or some form of monetary support to continue or else disappear curtailing a nation’s aspirations to promote domestic defence procurement.
Tough Choices Ahead, Perhaps
Whilst the defence industry is currently not affected as much as many other industries, it needs to keep in mind that defence contracts are typically of very high value, and a potential loss of business due to a COVID-19 will mean that companies lose out on hundreds of millions of dollars in anticipated sales.
Companies will also have to make tough decisions on how business is to be conducted in the future. Maintaining all assembly lines and maintaining an active workforce in the face of reduced sales is a challenging situation many companies will face. Typically, at this point businesses are faced with many tough questions such as: do they maintain the workforce level or trim it at the risk of losing capable people?; do they delay payments to vendors?; do they turn to governments for help?; o they divert R&D budgets towards paying salaries at the risk of losing technological edge?; or do they relocate production sites? How will they maintain shareholder confidence?. Defence companies must, therefore, work on future-proofing themselves, and be prepared with solutions and mitigations to such risks in order to deal with the uncertainties stemming from the many shocks caused by this and future pandemics.
Secondary effects due to stock price declines
A look at the stocks of defence companies that manifest visible shocks of the pandemic paints a worrying picture. At the time of writing since February Lockheed Martin’s stock price has fallen by over 27%, Leonardo’s by around55%, Thales’ by 33% and Fincantieri’s by 32%; shares of other defence companies are also trading at their lowest prices in the past 5 years. While trading in secondary markets does not directly affect incomes of companies, we need to be wary about its indirect consequences. Companies that planned to issue shares in the primary market to fund capital investments will have to hold off as low share prices are detrimental to successful public offerings, and business expansion plans will have to be deferred. Another more worrying consequence of this could be a potential loss of control or a takeover if other entities take the opportunity to buy them out whilst their shares are undervalued. Some defence companies will have to consider resorting to share buybacks in order to prevent such events from happening, this, in turn, resulting in more expenses and loss of liquidity for the firm, at a time when thriftiness is the need of the hour.
Possible Scenarios and the Way Forward
The discovery of a vaccine or cure in a few months and successful containment during the downtime will leave the industry less affected. Some contracts, defence events and business development measures will be pushed back but overall the defence sectors should just seek a tactical pause, and aim for compensating growth because of pent up demand towards the end of the year. Setbacks will be just temporary.
However, if the discovery of a vaccine or cure takes a lot longer than expected and containment efforts in the downtime are only moderately successful, we will see defence spending deprioritized and supply-side pressures causing defence companies to face tough decisions (as discussed under “Tough Choices Ahead, Perhaps”). There is no magic bullet for successfully weathering this scenario. Every company will have to make a different set of choices after carefully considering its financial conditions, the conditions in its target markets, the stress its supply chains are under and many other factors.
A third scenario is also plausible in which a vaccine or cure is completely elusive, and we may just have to learn to cope with SARS-COV-2 just as humanity has learnt to cope with myriad other diseases. In such a scenario, it might be unviable to continue a suppression strategy indefinitely and governments and businesses will have to turn to mitigation. We will have to “live with the virus” but defence businesses have to be prepared for suppressive measures whenever there is a resurgence.
Irrespective of how the COVID-19 scenario will turn out, there are some common lessons for the defence industry. Uncertainty in today’s world must be accepted as a norm and the defence industry must explore multiple facets of risk planning. The strategy should not just be focused on growth but must include scenario-based resource planning and material substitution. Manufacturing principles that advocated maximising efficiency and reducing costs through maintaining minimal inventory may not factor in the uncertainties that abound today. Such textbook principles will have to be modified before application. Technological interventions to increase automation levels and using unmanned systems for resource/ component/ subsystem delivery will help reduce downtime during shocks, as can increased additive manufacturing techniques; so-called 3D printing. Coincidentally, these happen to be two segments that many defence companies have strong capabilities in – though from a product standpoint. The related technologies are maturing fast and some of these technologies may have to be refocused inward on company processes, and not just on market-ready products and solutions being developed.
Benjamin Disraeli’s way of work of preparing for the worst, but hoping for the best seems to be a good paradigm for defence companies to follow in these uncertain times.