Acquiring prime contractor capabilities

Integrated defense and security solutions

2 Strategy&

Beirut

Fadi Majdalani Partner +961-1-985-655 fadi.majdalani @strategyand.pwc.com

Berlin

Dr. Jan Wille Principal +49-30-88705-898 jan.h.wille @strategyand.pwc.com

DC

Joshua Harris Principal +1-703-682-5630 joshua.l.harris @strategyand.pwc.com

Dubai

Alessandro Borgogna Partner +971-4-390-0260 alessandro.borgogna @strategyand.pwc.com

Leonardo Monti Principal +971-4-390-0260 leonardo.monti @strategyand.pwc.com

Florham Park

Randy Starr Partner +1-973-410-7604 randy.starr @strategyand.pwc.com

London

Bob Mark Partner +44-20-7393-3477 bob.mark @strategyand.pwc.com

Diane Shaw Principal +44-20-7393-6420 diane.shaw @strategyand.pwc.com

Los Angeles

Jono Anderson Principal +1-424-294-3736 jono.anderson @strategyand.pwc.com

Munich

Christian Burger Senior Partner +49-89-54525-546 christian.burger @strategyand.pwc.com

Stefan Frey Partner +49-89-54525-646 stefan.frey @strategyand.pwc.com

Dr. Hans-Joerg Kutschera Partner +49-89-54525-556 hans-joerg.kutschera @strategyand.pwc.com

Christian Burger is a Munich-based senior partner with Strategy& and is a senior member of the firm’s operations and engineered products and services practices. He has worked with numerous international clients in the aerospace, defense, technology, and healthcare industries, and focuses on strategic transformation, organization, and governance.

Dr. Hans-Joerg Kutschera is a partner with Strategy& based in Munich. As a senior member of the firm’s engineered products and services practice, he focuses on strategic transformations in supply chain, operations, and after–sales, primarily in the aerospace, defense, and security industry.

Diane Shaw is a principal with Strategy& based in London and a senior member of the firm’s engineered products and services practice. She has led numerous projects with defense and security clients in the U.K. and Middle East, focusing on strategy formulation and transformation, as well as the design and execution of operating models.

Dr. Jan Wille is a principal with Strategy& based in Berlin and a senior member of the firm’s operations and engineered products and services practices, with a focus on aerospace and defense. He has led numerous projects with commercial and public-sector defense and security clients on strategy formulation, operating model development, and operational excellence.

Contacts

About the authors

Stefan Frey, a partner at Strategy&, and senior associates Jonas Seyfferth and Andrew Suddards also contributed to this report.

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Governments in developed markets are scaling back on defense spending, which is forcing defense and security companies to identify new revenue streams. Fortunately for these companies, many governments in emerging markets are still increasing their spending and want to improve their defense capabilities. For defense contractors, this represents an opportunity beyond just delivering technology and equipment. Governments in emerging markets typically don’t have deep expertise with complex modern weapons systems and command and control structures. What they need are integrated, end-to-end solutions.

These are potentially very long-term and lucrative engagements for contractors. However, to deliver integrated solutions, they will need to develop capabilities beyond those of a traditional pure technology provider, and they must be able to help customers develop their own capabilities to support the project’s long-term success. Additionally, contractors need sophisticated service delivery mechanisms in order to implement all aspects of the integrated solution properly. Not surprisingly, these service delivery requirements — project management, risk management, and transformation management — all become increasingly complex the more integrated the solution.

There are four primary ways that contractors can fill their capability and service delivery gaps and become what we call prime contractors for integrated solutions: (1) internal buildup, (2) acquisition, (3) subcontracting, and (4) partnering. To be clear, not all contractors must become prime contractors for integrated solutions to participate in the emerging markets. Some will retain their focus on providing technology and equipment. However, we believe that developing prime contractor capabilities will put an organization in a more powerful position to compete in the global environment. As a prime contractor, a company has control over the total project, is close to the end customer, and can decide which subcontractors are involved in the project. This creates a value proposition that’s very difficult for competitors to imitate.

Executive summary

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The global defense and security industry is in the midst of a profound realignment. Budget cuts by governments throughout Europe, sequestration in the United States, the winding down of Western involvement in Afghanistan, and the continually changing nature of warfare are leaving many companies scrambling for new avenues of growth.

Historically, about 90 percent of the defense and security industry’s business has come from developed markets. But from 2009 to 2013, defense spending decreased annually by 3.3 percent in the U.K., 3.1 percent in the U.S., and 2.7 percent in France. At the same time, other business challenges in developed markets were becoming more acute. For example, strict regulatory and sovereignty have limited expansion opportunities. Companies outside the sector, such as IBM, Cisco, and Fluor, are capturing more market share (with as much as 40 percent of U.S. defense hardware spending now going to such commercial players). And as threats to national security such as cyber risks evolve ever more rapidly, OEMs need faster development cycles to respond.

As a result, many defense and security companies are casting an eye toward emerging markets, where budgets are on the upswing and where governments are now planning to modernize their homeland security and defense infrastructures to bring them up to par with Western counterparts. This opportunity is particularly pronounced in the Middle East, Southeast Asia, and Latin America. From 2009 to 2013, defense spending increased annually by 10.8 percent in the UAE, 8.1 percent in Saudi Arabia, 7.4 percent in China, and 1.3 percent in Brazil (see Exhibit 1, next page).

The emerging market opportunity

OEMs need faster development cycles.

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Exhibit 1Defense spending has increased in emerging markets as it has contracted in mature markets

Poland

China

France

U.S.

Japan

India

South Korea

Russia

Brazil

Saudi Arabia

UAE3

U.K.

Indonesia

Malaysia

Germany

Maturity Growth

-0.1%

0.1%

-2.7%

-3.1%

0.1%

-3.3%

0.1%

1.3%

1.4%

1.8%

7.1%

7.4%

8.1%

10.8%

17.8%

High

Medium

Low

Maturity index2

Development of defense spending Maturity and compound annual growth rates 2009–13, by country1

1 Average annual growth rates 2009–13 at constant 2011 prices and foreign-exchange rates. 2 Maturity based on military capabilities (people and information) and defense industry base (import versus export).3 UAE growth interpolated based on 2012 (no 2013 data available).Source: Stockholm International Peace Research Institute, Strategy& analysis

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Not only are emerging markets experiencing growth in their defense budgets, but the breadth and depth of their needs are in many cases greater than in developed markets. Few of these governments have conducted large-scale modernization programs, most are inexperienced with modern defense and security solutions, and they often rely on outdated command structures and strategies. They can afford technologically complex weapons systems, but they often lack the expertise to integrate and support such systems, and at times even use the hardware. For example, when introducing a C4ISR (command, control, communications, computers, intelligence, surveillance, and reconnaissance) system, organizations struggle with managing the new flood of data, drawing relevant conclusions, and initiating the appropriate response. As a result, many want integrated defense and security solutions that include everything from technology delivery to full capability implementation.

One possible way for a defense and security company to play in this environment is to become a prime contractor, which means providing the equipment, ensuring the customer has all capabilities in place to operate the new technology, coordinating all parties including subcontractors and other stakeholders, and assuming end-to-end responsibility for running the complete defense and security program.

The revenue potential is enormous. Integrated solution projects are usually big, billion-dollar-plus contracts spanning multiple years, providing the kind of long-term financing necessary for new product development. What’s more, the lengthy engagement gives the OEM in-depth knowledge about the customer, a chance to influence customer development in favor of the OEM’s product portfolio, and opportunities to sell additional technologies. For instance, a customer that wants to increase border security with better on-the-ground monitoring devices may eventually be persuaded to purchase unmanned aerial vehicles or helicopters to add air support.

Opportunities and challenges

Many emerging markets governments want integrated defense and security solutions.

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“A few years ago, we were selected as prime contractor for a multiyear defense and security program in the Middle East. A year into the project, the government official in charge was removed due to a bribery scandal unrelated to the project. The new official invalidated the contract and demanded a new approach to the project, with little concern for our investments already made in the first year.” —Country managing director, European OEM

However, these opportunities do not come without significant challenges. Agreements in these countries can be subject to change — even after contracts have been signed — through intervention by certain government officials, national politics, or public opinion.

Another challenge is defining the scope of the project and requirements for completion at the outset of the engagement. If this planning doesn’t occur, cost and time overruns are a risk, which undercuts the customer’s confidence. A third major challenge is coordinating the large number of stakeholders involved in an integrated solution. Clear project governance structures, a project management office, and well-defined roles and responsibilities are vital. A project can quickly unravel if coordination is lacking.

For instance, the defense community is currently looking at Brazil, where the first tranche of a US$6 billion border surveillance system was awarded to a local consortium of vendors. Given the multitude of involved organizations on the purchasing side (Brazilian Ministry of Defense, law enforcement organizations, etc.) and on the supplier side, experts consider stakeholder complexity and limited experience with large-scale high-tech security programs to be the main challenges.

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Based on our extensive work with companies and governments around the globe, we believe overcoming these challenges is a matter of having in place the right capabilities, as well as the right skills to deliver those capabilities to customers.

The aspiring prime contractor must build up the full complement of technical and nontechnical capabilities needed to deliver an integrated solution to customers. Also, and no less critically, it must be able to help customers develop their own capabilities to support the project’s long-term success. We use the “TEPIDOIL capability wheel” from the U.K.’s Ministry of Defence to illustrate the entire set of capability needs for an integrated solution. (TEPIDOIL is an acronym for training, equipment and technology, personnel, information, doctrine and concepts, organization, infrastructure, and logistics.) The more complete the capability wheel, the further a contractor has evolved from an equipment and technology provider to a prime contractor capable of offering an integrated solution (see Exhibit 2, next page).

Building capabilities

Start with the doctrine and overall strategy.

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Exhibit 2The TEPIDOIL capability wheel

Logistics Training

Doctrine andconcepts

Information

OrganizationPersonnel

Infrastructure

Interoperability

Equipment andtechnology

Note: Similar concepts are used in other markets — e.g. the U.S. uses DOTMLPF, which stands for doctrine, organization, training, materiel, leadership and education, personnel, and facilities. Source: U.K. Ministry of Defence, University of Cambridge, Strategy& analysis

Doctrine- and capability-led programs

Often, large modernization programs are driven by the right-hand side of the wheel — technology and infrastructure — given the technological expertise and mind-set of traditional contractors. The left-hand side, doctrine and concepts, is often neglected or addressed only very late in the project. This can result in the challenge of a customer receiving state-of-the-art equipment but lacking the organizational and conceptual capabilities to operate it.

Instead, we propose that any modernization program should start with the doctrine and overall strategy — derived from the threat situation and organizational capabilities — before defining which technologies should be acquired.

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Doctrine and concepts: Describing core processes and guiding forces in their actions today (doctrines), as well as defining the deployment of future capabilities (concepts). What’s the operational concept of leading a security force in the future? How are standard operational procedures defined? As noted above, modernization programs should be driven by the doctrines, but in reality, given the tech mind-set of the contractors, they are often “technology-led,” resulting in a mismatch of strategy and deployed technology.

Equipment and technology: The systems and weapons needed to equip an individual, group, or organization. This is the core of a capability. If the goal is to modernize ground forces, for instance, the customer will need technology such as infantry armor and weapons or heavy equipment such as battle tanks.

Logistics: Planning and conducting the operational movement and maintenance of people and equipment, including acquisition, storage, transport, maintenance, evacuation, and disposal. For example, for the restructuring and modernization of border security, the surveillance systems must be transported to the right places, and then maintained and repaired over time.

“Our client wanted to actively participate in the project to learn from us and to understand how to run comprehensive defense programs. However, involving their inexperienced staff in our day-to-day project work slowed us down and made it harder to get our work done within the agreed time.”

—Program manager, European OEM

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Infrastructure: The acquisition, development, management, and disposal of buildings, structures, utilities, and facility services. For example, garages and service workshops are necessary to provide effective maintenance for new vehicles and vessels.

Information: Managing data, information, and knowledge across the organization to ensure system interoperability. If maritime surveillance systems detect an object, for example, this information must be analyzed and then relayed to the command centers to process the data, distribute the information, and issue orders.

Training: Practicing technical and mission-specific skills as well as development of process knowledge. In short, people need to know how to operate new equipment and technology.

Personnel: The recruitment and deployment of sufficient capable and motivated personnel to fulfill the organization’s duties.

Organization: Organizational relationships of people, including military, civilian, and contractor structures. For example, a security force might comprise thousands of individuals with different roles, ranks, and hierarchies. An organization needs to define who is reporting to whom. Are there regional teams or central teams? How many people are stationed at each post, and so on?

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Building delivery skills

An aspiring prime contractor needs sophisticated service delivery mechanisms in place in order to implement all aspects of the integrated solution properly (see Exhibit 3). And these service delivery requirements — project management, risk management, and transformation management — become increasingly complex the more integrated the solution.

Exhibit 3Requirements for providing integrated defense and security solutions

Doctrine andconcepts

Organization

Personnel

Training

Information

InfrastructureCustomercapabilityneeds

Servicedeliveryrequirements

Serviceoffering

Hardwareonly

Maintenanceand logistics

Training andsimulation

Integratedsolution1

Logistics

Equipment and technology

Transformation management

Risk management

Project management

1 Including development of customer organization (e.g., strategy, operating model, organizational design, processes).Source: Strategy& analysis

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Project management tasks are significantly broader for an integrated solution than for a pure technology project. The project management teams must coordinate and track activities, and report on progress across many different stakeholders and inexperienced customers. Adding to the complexity is the highly dynamic environment in many emerging markets, where participants and schedules are often in flux over the course of the project. These challenges make proactive “issue management” and decision support crucial.

Risk management plays a critical role even before the start of the project. Given some of the “softer” goals of integrated solution projects — such as building up a new organization’s capabilities or formulating a new strategy — contracts must be carefully worded to ensure that milestones and goals are understood and the customer is willing to pay. After the project has begun, the broad scope of the project presents significant execution risk, and there are also various highly unpredictable external risks (e.g., political shifts).

Transformation management comes into play because integrated solutions are so broad and deep that they often result in the large-scale transformation of the customer’s existing organization and processes. This transformation requires long-term investment and bears its own significant challenge for the prime contractor. Managing such transformations within a client requires understanding the culture and the various formal and informal levers of change.

“In our first integrated solution project, we clearly underestimated the client’s need for getting support in restructuring their complete organization. They even asked us to rewrite their doctrines and standard operating procedures — something we haven’t done ourselves so far.” —Program manager, U.S. OEM

Risk management plays a critical role.

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Given the historical role of many OEMs as pure technology providers, most never developed the capabilities and service delivery mechanisms necessary for integrated defense and security solutions. In our experience, the capability gaps are often widest in the areas of organizational development and doctrine design, whereas service delivery mechanisms around transformation and risk are often tailored to classic technology projects and not suitable for the new challenges of integrated solutions. It’s critical that aspiring prime contractors close these gaps, and we have identified several strategies for doing so. An OEM’s decision depends in part on its starting point and individual project requirements (see Exhibit 4).

Filling in the gaps

Exhibit 4Customer needs versus OEM proposition: Mideast security program example

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Line Textures:

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Supporting grey and tints for all colour families

Grey

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20%70%

60% 40% 10%20%70%

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Maroon

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Exhibit X (Charter ITC Com Italic 12pt.)Title (Charter ITC Com Bold 12pt.)Helvetica Neue - regular 8pt. (source/notes) TBD

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Doctrine and concepts

Capability Low HighMedium

Gap

Organization

Personnel

Training

Information

Infrastructure

Customerneed

OEMproposition

Logistics

Risk management

Transformation management

Project management

Equipment and technology

Source: Strategy& analysis

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Internal buildup: The organic development of missing capabilities. This is a slow process that adds higher fixed costs to the organization; these capabilities must be utilized to justify their expense. However, internal buildup is a sustainable approach to adding capabilities. It’s best suited to large-scale projects matching the OEM’s strategic business development agenda (i.e., the OEM expects to work on other projects with similar capability requirements).

Acquisition: Targeted acquisitions of other companies with strengths in missing capabilities. This is more complex, requiring the identification and acquisition of target companies, as well as effective post-merger integration. Caveats aside, it is also a sustainable approach to building capabilities.

Subcontracting: Hiring specialized providers in areas such as IT. This is a “quick fix,” but it is costly and introduces coordination complexity. The bigger downside, however, is that it does not truly add capabilities; rather, the organization simply hires them for a finite period. As a result, subcontracting is often well suited to smaller, short-duration projects.

Partnering: Joining forces with another company with complementary competencies, such as a systems engineering and integration service provider, to offer all capabilities necessary for integrated solutions. Though this approach can be put into practice more than quickly than “internal buildup,” it demands a high level of coordination and quality control procedures. On the positive side, each partner has an opportunity to learn from the other during the collaboration and efficiency will improve with joint experience over time. In many cases, partnering can provide the best balance of risk and return (see “Capability Buildup through Partnering,” next page).

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Partnering with other organizations in the defense and security ecosystem is an effective way to close capability gaps for specific projects, but an OEM must undertake it with the utmost care (see Exhibit A).

• First, the contractor needs to define the capabilities necessary for the specific project, assess its own capabilities, determine which capabilities are missing, and identify potential partners that can bring these capabilities to the table.

• Next, OEMs should establish a stringent tendering and partner

selection process. By developing, maintaining, and fostering a partner network, OEMs can speed this process and also ensure interoperability of partner systems and services.

• Rigorous contract and subcontract management is also critical for OEMs, as well as service providers and advisors. This should also cover quality assurance and monitoring, and link payment processes to service delivery.

Implemented correctly, partnering can cover all capability needs, reduce uncertainty and project risks, and instill greater customer confidence.

Capability buildup through partnering

Exhibit AThe partner ecosystem of defense and security OEMs

Source: Strategy& analysis

Governmentagencies

Strategy andoperations advisors

Systems engineering and integration (SE&I) services

Systems engineering and technical assistance (SETA) services

Armed/security forces

Information systems/IT services

Pure-playdefense and security OEM

Commercial conglomerates

Civil works/ constructioncontractors

Other defense OEM/product specialists

Subcomponent manufacturers

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Prime contractor versus technology provider

Developing the full complement of capabilities allows a company to play the role of prime contractor, but that doesn’t mean the company must play this role in every case. In certain circumstances the contractor might choose the more limited, focused role of traditional technology provider with responsibility only for delivering and installing the technology and/or hardware.

There are downsides to this traditional role. A contractor has no control over key overarching program decisions, and its ability to up-sell is generally limited to maintenance and training. Still, there are good reasons a company with prime contractor capabilities might choose to go this route, such as reducing risk by not taking on overall project responsibility, lowering ramp-up costs (since no additional capabilities must be developed), and more efficient production with standardized products and systems. Even if a contractor chooses the pure technology role, some other entity is likely to be taking on the role of integrator, such as a service provider that specializes in project management of government/infrastructure projects.

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To decide which option is most appropriate in a specific situation, an OEM must weigh several factors:

• Strategic relevance/revenue potential of project: If the market for a specific defense solution is very small, then perfecting a set of capabilities around that solution may not be worthwhile.

• Match of OEM capabilities with project requirements: If a contractor must strike several partnerships to offer all necessary capabilities for a specific project, it may decide the coordination complexity is too expensive or risky.

• Customer background and competition: Domestic contractors are often given preference when bidding for government contracts; this may make acting as the prime contractor impossible, or simply too difficult if the company is forced to work with certain domestic subcontractors.

• Project environment and geography: The project environment can become very complex if there are many competing stakeholders and/ or the reporting and auditing requirements are cumbersome. Another complexity is geographic distance between the OEM home market and the project location. This may require the construction of new offices in remote locations, hiring expats, and long transport routes.

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Conclusion

The desire by governments, particularly in the emerging markets, to modernize their defense and security capabilities creates a growing need for prime contractors that can offer end-to-end integrated solutions. That’s not to say all contractors must become prime contractors. There will still be a role for the pure technology plays, which are less risky in the short term because they have lower fixed costs and aren’t under pressure to utilize all TEPIDOIL capabilities. In fact, even companies with prime contractor capabilities will sometimes choose to play a more limited role for certain projects. The difference is that prime contractors will have a strong and sustainable value proposition that’s very difficult for competitors to imitate.

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