Defense contractors- a world full of politics, corruption, and incompetence

Arms manufacturers are capable of making weapons that help win wars- but surprisingly enough, their customers don’t care about that.  The root of the problem is with political leaders- their interests tend to lie in buying votes.  As well, the skillset of getting elected does not overlap with the skillset of choosing competent military leaders.

As a result, the world’s richest nations often purchase weapons without any realistic testing and later discover that they do not work.  The Patriot missile defence system likely did not shoot down any Scud missiles from Iraq.  Worse still, they likely increased overall casualties as stray Patriot interceptor missiles hit civilian apartments (see page 9 of “Evaluating Weapons: Sorting the Good from the Bad“).

From an investing perspective, the history of corruption is interesting as it stretches back for decades.  During the Vietnam war, the US Army’s ordinance bureau intentionally sabotaged the M16 rifle with ammunition that would cause the rifle to jam more frequently (see page 3).  Since then, abuses have continued despite exposure in mainstream media.  Chuck Spinney was on the cover of a 1983 TIME magazine; the 1998 TV movie Pentagon Wars explained issues with the Bradley Fighting Vehicle (clip).  This suggests to me that the corruption in the US is fairly resilient, entrenched, and will likely continue to grow at a slow pace.

Unlike other industries, arms manufacturers do not compete on innovation, quality, or price.

Understanding what makes a weapon good

For a deep dive, see Pierre Sprey’s paper “Evaluating Weapons: Sorting the Good from the Bad“.  Some of Sprey’s viewpoints may seem extreme or hard to believe.  He argues that a commonly recurring abuse is that weapons testing lacks honesty and does not try to replicate combat conditions.  For example, the Israelis found out the hard way that they should have used less flammable hydraulic fluid in US-supplied tanks.  In the Yom Kippur war, hundreds of soldiers were killed when their tanks caught on fire from hydraulic fluid and fuel fires (see page 3 of “The terrible cost of not testing with real weapons shooting at real targets“).  The Americans and Israelis did not try to fire live ammunition at a combat-loaded tank to see the tank’s vulnerability to fire, despite the obvious benefits from such a test.

Past abuses continue today

The US military still buys untested equipment like the F-35 fighter; the US military calls it “concurrency” or “low rate initial production”.  The US and its allies have taken delivery of F-35s before all operational testing has been completed- and before the F-35 was ready to fire weapons like missiles and bombs.  In other words, countries have bought pre-production planes years away from combat readiness.  This practice entrenches a weapons system since politicians are less likely to cancel a weapon when it has already generated jobs.  Concurrency gets the foot in the door.

Why don’t the customers care about quality?!

I would attribute it to a mixture of corruption, politics, and incompetence.  Corruption alone does not explain everything that goes on.

Politics

Part of the problem is that defense spending generates jobs and therefore ties into “pork barrel” politics.  Manufacturing of a single weapon is often spread across many different congressional districts, ensuring broad support for manufacturing that weapon (regardless of its merits).  Weapons with significant export sales tend to have manufacturing spread out across participating countries.  In somewhat rare cases, the US buys new planes and tanks that they have little or no use for.

Then there’s the issue of optics and looking good to the bosses.  The politicians and procurement officers have a vested interest in hiding their failures and trumpeting their successes.  This is why the US military buys weapons without honest testing: testing would reveal flaws.  Realistic testing may reveal that a new weapon is inferior to what it’s replacing.  And without testing, there is no incentive for weapons manufacturers to produce weapons that actually work.  Instead, they are incentivized to “advise” militaries on how to rig test results for the token testing that the weapons undergo.  And in some rare cases, some military officers will fabricate the desired test results.

Incompetence / ideology

The US Air Force (USAF) has been trying to get rid of the A-10 close air support (CAS) plane.  This is not a decision driven by personal gain from contractors as the A-10 has generated a steady stream of contracts for upgraded avionics, wing replacements, etc.  A replacement for the A-10 would generate a lot of money for contractors… yet the USAF has no plans for an A-10 replacement.  And because the A-10 has much lower operating costs than other USAF aircraft, the money saved can go towards the generals’ pet projects.

Rather, the real reason is that the USAF doesn’t like the CAS mission.  The generals would like to think that they can win a war solely through air power.  (Historically, this has never worked.  Pierre Sprey makes a good argument that CAS is the most important mission of an air force.)  They don’t like CAS because it helps other military branches win a war.  The USAF is not alone in this view.  Other air forces do not see the value of CAS and do not buy the specialized airplanes needed for CAS.  In conflicts against insurgent armies, specialized aircraft are needed since the aircraft need to fly slow and low to the ground.  This lets the pilot spot the difference between insurgents and civilians, to fly under cloud cover that interferes with weaponry, etc.  Against conventional armies, airplanes are a better idea than helicopters since maneuvering airplanes are harder to shoot down (many militaries use helicopters for CAS).  So while the A-10 has an impressive track record in numerous conventional and unconventional wars, the A-10 did not see any export sales unlike other less effective aircraft.

For ideological reasons, military effectiveness does not lead to wide commercial success.

Lastly, there is an obsession with technology that tends to produce mediocre weapons.

  1. Unproven technologies often don’t work.  While risk-taking is essential for innovation, there is no mechanism for rejecting failed technologies.  The culture of hiding flaws and deficiencies means that militaries buy equipment that rarely works as advertised.
  2. Proven technologies that don’t work continue to be implemented.  Dogmatic views about the value of ‘high technology’ tend to be stubborn.  Militaries continue to chase the promises of stealth (which doesn’t work against low-frequency radar; all early-generation radars were low frequency) and radar-guided missiles (infrared missiles work better in practice).
  3. Poor project management (made worse by layering on complex and unproven technologies) often leads to cost overruns, leading to weapons that are so expensive that only limited quantities can be purchased.

Investing takeaways?

When it comes to competitiveness, I would argue that the most important factor is a company’s ability to pander towards corruption, politics, and incompetence.  However, history is not entirely clear about this.  Fairchild Republic, which is the same company that made the A-10 (after winning a fly-off against the Northrop YA-9), had to close its Farmingdale factory when it lost its T-46A production contract and no longer had any government contracts left.  The closure was driven by poor management on Fairchild’s part (described by a former product manager and in a New York Times article); however, the US military has bought many planes that were well behind schedule with massive cost overruns.  It could be the case that companies with bribery controversies (e.g. Lockheed, Northtrop, etc.) fare better financially than companies with few or no bribery controversies.  I didn’t find much evidence that Fairchild was savvy in terms of bribery or spreading out production across multiple congressional districts.

Secondly, defense contractors’ fortunes will ebb and flow with American defense spending.  Because arms procurement in the US military branches is broken, one might think that the game might change dramatically someday when politicians attempt to fix the system.  For-profit education stocks were ravaged when industry subsidies (in the form of student loans) ended.  However, history suggests that the defense industry will stay resilient as it successfully fought off the military reform movement.  It could be the case that it is more difficult to disrupt a very large industry compared to a subsidy for a small industry.  As well, many other countries around the globe have problems similar to the US (e.g. look at the customer list for the F-35).

Overall, none of the defense contractors currently seem to exhibit unusually high rates of earnings growth, likely because the marketplace is mature and saturated.  Returns on capital are high but not excessively so.  My hunch is that major defense contractors like ESLT, GD, LMT, NOC, and RTN will slightly outperform the S&P 500.

 

*Disclosure:  I don’t own any defense stocks.

2 thoughts on “Defense contractors- a world full of politics, corruption, and incompetence

  1. For an inside look at the Pentagon’s ridiculous bureaucracy, you should read this book:
    Boyd: The Fighter Pilot Who Changed the Art of War

    It’s scary when military leaders consider the fighting effectiveness of their forces & equipment to be a tertiary concern. I’m surprised that guys like Sprey, Spinney, and Boyd stick around as long as they do. Most people either start drinking the Kool-Aid or get the heck out.

    It’s not very inspiring for the guys on the front line using substandard equipment so some guy in Washington can play “pork barrel” politics and get re-elected.

    • Thanks for pointing out that book… it’s an interesting read.

      And when I first started researching it, I was surprised to find something more broken than the US healthcare system.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out /  Change )

Google+ photo

You are commenting using your Google+ account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s

This site uses Akismet to reduce spam. Learn how your comment data is processed.