Why Increasing the Value of Defense Primes Is Good for the Country
In March 2023, the Department of Defense released a report declaring, “In aggregate, the defense industry is financially healthy, and its financial health has improved over time.” In fact, few people would argue that — at least for those companies that beat the odds and survive the “valley of death” — defense contracting isn’t a lucrative business. But if the defense industrial base, and in particular America’s traditional primes, is so healthy, then why is the government spending so much money to get so little innovation into the hands of servicemembers? This is a puzzle that itself speaks to the bipartisan calls for the recently concluded Commission on Planning, Programming, Budgeting, and Execution Reform.
The most common, and cynical, answer is to blame defense contractors and the primes themselves — for example, they’re taking too much profit, prioritizing shareholders over warfighters. Secretary of the Navy Carlos del Toro made a comparable argument earlier this year when he accused shipbuilders of “[goosing] stock prices through stock buybacks, deferring promised capital investments, and other accounting maneuvers … rather than making the needed, fundamental investments in the industrial base.” It is certainly justified to call out irresponsible corporate behavior where it exists, but it is also important to recognize that the root cause of such behavior may be found beyond industry itself.
First, while some individuals may prioritize financial gain, in my experience, most members of the defense ecosystem are mission-driven and build with warfighter needs at top of mind. Second, while part of the public’s enduring cynicism toward a strong defense sector, and fear of a military-industrial complex with “unwarranted influence,” can be traced to President Dwight Eisenhower’s farewell address in 1961, the perception of the defense industry being unduly large and influential has outlived reality. Over the decades, the relative weight of the U.S. defense industrial base has shrunk substantially, with a decrease in the size of defense firms relative to the national economy and contemporary defense spending (as a percentage of gross domestic product) near historic lows. Third, as some may not realize, traditional defense contractors are often contractually limited in the amount of profit they can make on government contracts, and defense firms tend to have operating margins of about 11 to 13 percent (significantly lower than the commercial margins of leading tech firms like Google at 27 percent, Microsoft at 44 percent, or Apple at 34 percent, per latest Securities and Exchange Commission filings).
The truth, therefore, has more to do with the effects of the Defense Department’s own acquisition preferences, rules, and regulations. By preferring a cost-plus approach to pricing, allowing companies to bill their independent research and development costs to the government, and capping profit margins, the Defense Department is inadvertently driving up purchase costs, decreasing incentives for private commercial investments in groundbreaking research and development, and ultimately creating an environment where the Pentagon is paying more for less innovative capabilities. In short, the defense sector is not healthy by the only measure that matters: the military getting the best possible innovation at the best prices.
If the United States is going to successfully deter and, if necessary, fight the next Great Power war, the Defense Department is going to need to squeeze every ounce of innovation and capability — hardware and software — out of its industrial base. So how can government and industry work together to nurse the public-private partnership back to health? Here, I offer a counter-intuitive solution to ensure the Pentagon gets more innovation and value for what it pays: Make America’s primes more valuable. As a senior executive at Palantir Technologies, a publicly held software company that does substantial business with the Defense Department, we have a commercial interest in this outcome. But I hope the reader will see that I am offering this as a sincere and experience-based proposal to help bring greater innovation at lower cost to the Defense Department.
As such, the argument is not that government should guarantee higher profits with new handouts or regulations. As Air Force Secretary Frank Kendall argued nearly a decade ago as part of the Better Buying Power initiative when he was serving as undersecretary of defense for acquisition, technology, and logistics:
Profit should be reasonable, and higher profit levels should be tied to better performance and lower profit to poorer performance. Our analysis shows that industrial performance responds to the incentive structure that the Department designs into our business arrangements.
Giving defense primes the opportunity to earn their higher profits will catalyze the flow of private capital to defense research and development (shifting the burden of risk away from the average taxpayer), promote greater innovation, and subsequently drive down the costs of government spending.
Together We Fall
Both the Pentagon and industry primes are not currently meeting their collective potential. While traditional primes will always be production powerhouses, they spend relatively less on ground-breaking research and development — compared to their new entrant defense tech peers — because they face few incentives to take big innovation and production risks that create the types of new capabilities that exceed the Pentagon’s own imagination. At the same time, the Pentagon (that is, the taxpayer) largely pays for its own research and development — often reimbursing primes directly — which drives up capability costs and means it has to buy less for more. Simply put, neither the Pentagon nor America’s primes are operating at their greatest potential and efficiency for one simple reason: In the world of defense acquisition, the free market ceases to operate.
The parts of our economy that work best develop products at investor, not customer, expense. And private capital investment is itself incentivized and protected through the spoils of licensed and protected intellectual property. For the most innovative capabilities — including the type America’s warfighters need — product development costs are sky-high and full of technical and execution risk. As such, although many companies are unable to sustain that risk for long, for those that can survive commercial trials and tribulations, their intellectual property does eventually become valuable (and rightly so).
However, while this is how things work in the commercial sector, this is not how it currently works for most prime contractors, and the economics show it. One dollar of revenue from a traditional prime is worth between one and two dollars in enterprise value, but one dollar of revenue from a commercial technology firm is worth five to 20 dollars in enterprise value. For example, based on data from S&P Capital IQ, as of March this year, the six traditional primes are collectively worth (by enterprise value) only 53 percent of Meta but have more than twice as much collective revenue. This is because the market values the revenue of Meta at a higher multiple than the revenue of the primes, reflecting the market’s belief in the growth potential of Meta’s products and rewarding it for high margins. A similar comparison can be made with Microsoft; the primes are collectively worth 21 percent as much as Microsoft but have 39 percent more collective revenue. Under normal market forces, America’s defense primes could double their value while halving their revenue. Yet this outcome can only be achieved by transforming the business model of primes, which itself is significantly influenced by the Pentagon’s own non–free market incentives.
There are three key features of defense contracting that impede the free flow of private capital, moonshot research and development investments, and profits — each of which limits the ability of primes to subsequently increase their value, and each of which exists because the U.S. defense market has only one buyer who can manipulate producer interests and behavior — that is, a monopsony.
First, traditional government acquisition guidelines allow independent research and development costs as a reimbursed expense. As a result, contractors are incentivized to spend government money on conservative research and development projects instead of spending house money on the types of highly speculative investments that truly push the bounds of technology to deliver new capabilities. Worse still, in this case primes invest not private capital, but rather taxpayer dollars, into the research and development for their most consequential products. Can you imagine if Microsoft sought reimbursement from its customers for its failed Windows phone? Or if your next iPhone included a surcharge for Apple’s $10 billion write-off on the failed self-driving car? The whole point of American private industry is nothing ventured, nothing gained. And as a result of anti-capitalist regulation, primes are disincentivized to venture, and accordingly, America’s warfighters gain less.
Second, even if primes wanted to invest vastly greater sums into research and development, they would face even further constraints due to artificial limits on contract profit margins. Federal Acquisition Regulation guidelines, which govern a large portion of the Defense Department’s procurement contracts, stipulate in Section 15.404-4 I(4)(i) that — depending on the contract — profits must be capped at either 10 percent or 15 percent. Of course, like most regulations, its source comes from good intentions: Capping profits on government contracts is seen as a block against unfair price-gouging. Yet aside from being wildly anti–free market, government-induced caps on profit margins mean primes receive less returns to reinvest in industry-defining research and development, and even less reward if those investments pan out. For example, under the current model, the government would prefer a $1 billion solution with 10 percent profit than a $500 million solution with 50 percent profit (which is the very thing that deep research and development in technology can deliver). Capped profit means the only actual provider of technology is the government since the economics are simply not viable for others.
Third, even if — despite independent research and development investment incentives and capped profits — primes decide to make heavy investments in high-risk, high-reward research and development, there would be little guarantee they could reap the financial rewards of their private investments. This is because of the Defense Department’s insistence on owning commercial intellectual property, which neutralizes the fiscal benefits from all that accepted risk.
The end result is that not only is the profitability (and value) of primes artificially capped, but the primes also face increasing market incentives to avoid high-impact, large-scale investments in commercial research and development. Furthermore, this anti–free market behavior ultimately shifts the financial risk of defense production onto the taxpayer, when it could (and should) be carried by private investment. Jerry McGinn, Mikhail Grinberg, and Lloyd Everhart were thus correct when they recently argued in Defense News:
If large defense primes are not making significant investments, it is because they believe that this incremental dollar is unlikely to materialize into a profitable contract in the future. For that to change, these primes need to see a better return for the earnings they intend to retain and reinvest.
Cost-plus contracting with capped profits — along with the extraordinary amount of spend required to monitor, track, and audit contractor expenses — is a disservice to American prosperity, the taxpayer, and, most importantly, servicemembers. American industry needs to be shaken off this cushion of low but stable profits, and one way to do that is to unleash their profit potential to drive up research and development investment and drive down production costs. If we can do this, America’s biggest industrial base producers can begin to better deliver capabilities the government needs (not what it wants) at a higher margin and lower cost.
How to Make Defense Primes as Valuable as They Can (Should) Be
Amending the above forces — independent research and development budgetary requirements, capped profits, and the Defense Department’s insistence on intellectual property ownership — can create win-win-win conditions in which taxpayers are no longer expected to pay for independent research and development, the primes can use profit-based incentives to invest in deeper tech, and the Defense Department can gain access to better technology for less.
More specifically, primes must rotate their business model away from cost-plus and toward privately funded (that is, non–government reimbursed) research and development to build up intellectual property and product portfolios that have commercial item pricing. In doing so, their revenue may shrink as they focus on higher margins and product-driven work, but their valuation will increase as the stock is re-rated (meaning they will have higher price-to-sales multiples). For example, if Lockheed Martin’s revenue was cut in half but its multiple tripled, its valuation would rise 50 percent. And that means there is $35 billion of additional defense budget to invest in more capability delivered through innovative product companies, like new entrants in defense tech ecosystem. But it also means that Lockheed Martin’s investors would be very happy, as would the warfighter.
Source: Author’s analysis using data from S&P Capital IQ as of 3/25/2024
To achieve this, the U.S. government could shift to a commercial model where it puts demand signals out on a list of desired capabilities and then buys them by trying them. Through privately funded competitions, where firms have more flexibility in how they build capabilities, the Pentagon might even find they value things they hadn’t thought of before industry invented it.
From a more tactical perspective, what can government and industry do to help bring about this change? First, the Defense Department can work to break its own monopsony by encouraging at least intra-Pentagon competition — between program management offices, services, and combatant commands — for industry solutions. Second, the department can help reform Federal Acquisition Regulation Section 15.404-4 to remove capped profits and unleash market incentives for greater private capital investments in defense research and development. Third, the Defense Department can temper its unnecessary insistence on owning the core intellectual property of its commercial providers. Venture capitalist Julia van der Colff explains what the result would be:
The emergence of new defense contractor business models that generate value from innovations in manufacturing, efficiency, and scale — rather than sustainment and maintenance — would also make the sector more attractive to venture capital investors who have traditionally avoided the industry, creating a multiplier effect and bolstering the overall industrial base capacity in the United States.
Importantly, however, we cannot expect the government to be solely responsible for change, and so industry must step up as well. As such, a third change is for primes to openly welcome and commit to trading higher profits for greater research and development investment, higher failure rates, and lower production costs. Like today’s venture-backed defense tech start-ups, they need to push the bounds of innovation and build to win. In the words of Thomas McNaugher, “Defense firms must promise to do good R&D to win contracts. Over the long haul they have to deliver on those promises to stay in business.” Fortunately, a revival of free-market mechanisms will naturally encourage such behavior; as the above referenced op-ed correctly argued, “The beauty of a commercially viable defense industry is that its participants are responsive to incentives.” But the primes may still need to be the first mover to build trust with the Pentagon, Congress, and the taxpayers. Toward that end, to ensure that industry gains make it back to the warfighter — and not back to company coffers as cynics fear — the primes can voluntarily pledge a minimum percentage of increased contract-based margins to be reinvested in commercial research and development.
Finally, it is necessary to recognize that improving the financial health of America’s primes will also elevate the broader defense tech ecosystem, populated with innovative nontraditional and early-stage firms. To sustain a healthy defense tech ecosystem, start-ups need to be able to exit at five to ten times revenue; but with primes trading at only one or two times their own revenue, they’ll never be able to acquire these new entrants. With greater profits, primes can not only supplement internal research and development, but they also can level up their capabilities by acquiring innovative start-ups. A successful (and profitable) liquidity event for start-ups, in turn, will help sustain the vigorous cycle of private-sector investment in the defense innovation ecosystem, which itself is driving talent to the national security sector and leading to more cutting-edge technological advancement for the warfighter.
Conclusion
At some point, we either believe in free markets, the innovation, and the resultant prosperity it has brought the United States, or we don’t. Based on the laws, regulations, and behaviors that drive government acquisition and contracting today, it is clear that Congress and the Defense Department do not. Cost-plus contracting is creating zero-sum dynamics and impeding the natural flow of capital and talent toward America’s national security challenges. And besides being anti–free market, it is shifting all innovation risk to the taxpayer and away from those who can and should bear the burden: private industry.
But there is a way out that benefits us all. Improving the value of America’s primes is good for investors, good for the Department of Defense, and good for defense tech new entrants. The rise of the defense tech ecosystem, with more nontraditional start-ups than ever before, is not a challenge to the health of America’s traditional primes. On the contrary, their rise can and should be sustained by their seasoned hardware peers. This is why, as the chief technology officer of a software company and supporter of new entrants, I am comfortable making the case for stronger hardware primes. America needs every contributor in our entire ecosystem — hardware and software providers, primes and start-ups — healthy and aligned. One way to ensure this is to embrace what has sustained American innovation from the beginning: the free market and private capital.
Shyam Sankar is the chief technology officer of Palantir Technologies.
Image: Donna Miles
