The Pentagon Report to Congress: What Defense Investors Need To Know

The Department of Defense has long-term concerns about sourcing materials and components and attracting talent. Those worries create challenges and opportunities for the defense sector.

A U.S. Marine Corps Lockheed Martin F-35B fighter jet hovers over the runway at the Farnborough International Airshow in Farnborough, Britain, July 15, 2016. Photo: REUTERS/Peter Nicholls

By Lou Whiteman, Motley Fool.

It's a great time to be in the business of war, as defense contractor order books have swelled. This has occurred due to the need for replacement armaments after years of dropping bombs in support of operations to fight global terrorism and a defense buildup to counter threats from North Korea and elsewhere.

Alas, that soaring demand has placed stress on the supply chain and has the Department of Defense worried about the industry's ability to meet future production targets. Among the chief concerns outlined in the Pentagon's annual Industrial Capabilities Report are potential issues sourcing components to replenish bomb stocks, a reliance on China for critical materials, and an aging workforce.

"Factors such as obsolescence, foreign dependency, fluctuating demand, industry consolidations, and loss of design teams, and manufacturing skills for critical defense products continue to threaten the health of the industrial base, limit innovation, and reduce U.S. competitiveness in the global markets," the Pentagon wrote in the report, which was issued in mid-May.

Here's a breakdown of some of the chief Pentagon concerns, and what they might mean for defense investors.

An uneven supply chain

The Pentagon placed a heavy focus on replenishing munitions in its current and fiscal 2019 budgets, committing more than $20 billion to buy bombs and missiles, but it's worried the industry isn't ready to deal with the increased demand. Part of the problem is of the government's own doing: The Pentagon admits its uneven year-to-year history of buying munitions has led some key domestic suppliers to discontinue — or at least de-emphasize — the business.

What remains of the supply chain is, at times, foreign owned or reliant on countries like China for key subcomponents or materials. The report says that about 60 elemental components go into microelectronics today, up from about 12 minerals in the 1980s, and frets that the United States currently imports more than half of its consumption of non-fuel minerals.

The Pentagon also has cut corners by relying on updates to, at times, multi-decade-old munitions, including the mainstay Tomahawk missile, instead of funding development of new programs. "As a result, the design skills for critical components within the missile sector industrial base are at risk," the report concluded, warning the loss of design and production skills could lead to delays, unexpected issues, and a lack of readiness.

Two contractors, Raytheon (NYSE:RTN) and Lockheed Martin (NYSE:LMT), are involved in roughly 97 percent of the Pentagon's munition and missile procurement funding. The report could present both a risk to those companies should the government seek to diversify or a boon if future appropriations prioritize funding for new-program development.

The Pentagon also is worried about component suppliers. The report says there are currently only two makers of solid rocket motors, a military-only technology, and only one manufacturer of thermal batteries. Fuzes are another area of concern but for the opposite reason: The report says that there's so much international supply, manufacturers aren't investing in technological improvements.

Greener pastures elsewhere

So much for the military-industrial complex. Dwight Eisenhower might not have believed it possible back when he popularized the phrase in the early 1960s, but in an era of iPhones, DVRs, and server farms running online commerce, the Pentagon is worried it's not big enough to adequately influence the electronics sector.

Global military production represents just 6 percent of the $1.5 trillion worldwide electronics industry, according to the report, giving the Department of Defense "limited leverage" over production trends. Off-shoring is another worry, with Chinese companies, for example, owning about 50 percent of the $60 billion printed circuit-board market compared to a 5 percent share from U.S. companies. Given the increasing importance of electronics, including sensors and radar systems, to modern warfare, as well as some of the unique requirements for military electronics, the Pentagon needs to make sure it has a steady supply of electronics from trusted sources.

This fear should create opportunities for defense electronics specialists, including Raytheon, Lockheed, Northrop Grumman, and General Dynamics, with the government conceding that it could be prudent to subsidize certain electronics projects to make sure prime contractors are willing to take them on. There are also increased opportunities for the Pentagon and the primes to capitalize on non-military technological advances. For example, Lockheed is developing an autonomous truck that would reduce the personnel needed to convoy supplies through dangerous war zones.

An aging workforce

Demographics also are working against the industry. Only 39 percent of aerospace and defense (A&D) employees are younger than 45, according to the report, and the industry is having trouble filling the estimated 27,000 open positions within A&D companies. The Pentagon said that while younger workers are interested in the industry, the engineering, science, and math backgrounds that are most in need also are in demand elsewhere.

"Although recent efforts focused on advanced manufacturing have helped to level off the decline in manufacturing jobs during the past few years, manufacturing's share of employment and gross domestic product (GDP) remain at historic lows," the report said. "This has led to a growing shortage of well-trained and capable manufacturing workers."

The government in 2017 held a series of meetings with the Aerospace Industries Association, a trade group, about workforce challenges. The industry and individual companies are encouraging fellowships and sponsoring scholarships to try to drum up interest, but investors should be warned that the problem is unlikely to be solved without higher wages and increased training expenditures. The government might shoulder some of that burden, but it figures to impact corporate profits, as well.

What this means for defense stocks

None of these issues are directly the fault of any one defense prime, but all of the companies figure to be impacted. When your entire business is focused on one customer, you tend to take that customer's concerns seriously.

There's a lot of potential profitability risk contained within the report, as rebuilding the domestic supply chain, attracting and training new workers, and sourcing materials from only select regions will bring up costs. There also could be opportunities, especially for large second-tier suppliers like L-3 Communications, to fill the domestic void in areas including electronics where the Pentagon is looking to invest.

But the most important takeaway from the report is the Pentagon's willingness to help solve the problems it has identified. Just as the defense industry needs to cater to their most important customer, the Defense Department is eager to sustain a healthy supplier base and is unlikely to force new requirements on companies without helping to pick up the bill.

The nation's biggest defense contractors have challenges on the horizon, but those challenges will create opportunities. This continues to be an industry worth holding for the long haul.

Lou Whiteman has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.