How to recapitalize America’s bloated defense industrial base

Chris Gates:
Okay, I'm recording on my end.

Danny Crichton:
And I think we're at least at the point where we have technically gotten a podcast show ready to go. Everyone's recording, everything says good.

Chris Gates:
You ready?

Danny Crichton:
Yeah.

Chris Gates:
Three, two, one.

Danny Crichton:
Hello, and welcome to Securities, a podcast and newsletter devoted to science, technology, finance and the human condition. I'm your host, Danny Crichton, and today we're talking about the mid-market industrial base for defense in the United States. Over the last year we've seen in Ukraine and all around the world an increasing need for the United States to be engaged in conflicts that are increasing in the 2020s. And unfortunately over the last two decades we've seen a huge narrowing of the number of companies that are able to produce the defense technologies that the United States needs to project power overseas.

And so we thought how do we go and solve this problem? And one part of it is getting more capital to the companies outside of the biggest primes and making sure they have the resources they need to get growing and building. And so today we're bringing together two folks to talk more about this industrial base and how those companies are getting funded. First is Hondo and second is Steve Carpenter, CEO and founder of Thematic. Thank you so much for joining us.

Hondo Geurts:
Awesome.

Steve Carpenter:
Great to be here.

Danny Crichton:
So, Hondo, I'm going to start with you. You've been a long-time executive in the Pentagon and most recently the head of naval procurement, which I believe is a couple dollar budget of buying aircraft carriers, planes and all kinds of other hardware. Why don't you give us a lay of the land of where hardware and acquisitions looks like for the Pentagon's perspective today?

Hondo Geurts:
Yeah, it certainly was about a $148 billion a year enterprise. So just a few things, and everything from submarines to airplanes to everything in between. This topic is really important and I think for Americans, they may not have realized how important it was until you see what's going on in Ukraine and you understand the importance of having a robust, resilient industrial base, or I like to call it industrial network.

And I think over the years we got in this mindset that we could separate national security from national prosperity. And so we find ourselves in this challenge of what I would call a industrial base that's kind of like World War II plus 4%. It's been merging, it's been consolidating, it's been efficient, but it's fragile and brittle. And unfortunately as the world gets more and more dynamic, these trends are probably not going in the right direction.

As the head weapons buyer, whether it was at Special Ops or for the Navy and the Marine Corps, I began getting very concerned that we weren't leveraging all the capability we had as a nation to keep us both safe and prosperous going forward. And so I think over the last couple years the realization that that challenge is out there has become more and more widespread. And so now it's all of our duties to out how to reverse those trends and leverage all that we have available in the country to, again, both support us economically and from a national security perspective.

Danny Crichton:
And of course we had a very resilient industrial base throughout the Cold War. There was this pressure from the USSR to make sure that we were fully up-to-date. We had a lot of options. It was diffuse all across the country in a way to sort of prevent nuclear war from knocking out any specific part of the industrial base for defense. And then we had the 1990s with the peace dividends, so the idea of cutting back Pentagon procurement intelligence. And I think we're swinging back all the way to the other side now, which is 20 years later, that peace dividend, we're sort of realizing hollowed out a lot of... And not maybe at the top of the largest and most advanced in edge equipment, but that kind of mid-market, all the core technology that kind of underpins all of the operations and logistics overseas.

Hondo Geurts:
The trends are actually pretty disturbing. Everybody talks about the '90s, where we certainly had consolidation, but actually I looked at the numbers. Over the last 10 years DOD spend is up 23%, even at the number of small businesses involved in the DOD is down 43%, and even at large businesses it's down 7%, and we've completely lost the middle of the industrial base. As we get into this world situation which requires manufacturing capability and being able to agilely transition and bring new products and technologies in, we find a larger and larger budget going to a smaller and smaller number of performers. And that's a disturbing trend for me personally, and I think for all of us as a nation.

Danny Crichton:
And how much are those trends driven by large projects like the Gerald R. Ford aircraft carrier, the F35? Are those sort of driving that kind of consolidation?

Hondo Geurts:
No. I think one of our challenges in the article I wrote with Joe Botel talks about this. We still have an industrial age mindset. And in the industrial age, in World War II, it was come up with a design, freeze the design, spend a year or two building the tooling, set up a manufacturing production line, and then build the thing. And that's kind of not how the world's working these days, where commercial has gone to network thinking and service thinking and much more dynamic. Even in some hardware manufacturing elements we still think of big capital projects and a very industrial mindset.

We develop a program and then we decided to produce a program and, hey, listen, we're still going to need industrial capacity, and as a nation we lost a lot of that manufacturing overseas and we've got to rebuild that. But we've also got to figure out how to bring in all of this new thinking that has caused this explosive growth in the more commercially developed technologies.

Danny Crichton:
Well, I mean, one of the things that was disturbing to me, I mentioned it in the Securities newsletter a couple of weeks ago, Alex Vershinin, who was writing a commentary for the Royal United Services Institute, a very prominent military think tank in the UK, was looking at the stockpiles of weapons, specifically javelin missiles going to Ukraine. And the US government is backing Ukraine. It is delivering arms and other support to the government there. And we found out that Lockheed Martin produces about 2,100 missiles a year. It could ramp up to about 4,000. And according to some estimates Ukraine was firing more than 500 a day. And so you're looking at this huge gap between what the needs are in the world, whether it's for the United States or its allies, versus the actual production capacity of a lot of these factories going on today.

Hondo Geurts:
Yeah, and I think, you know, listen, America loves, and particularly American military, loves technology and complexity. We love to make the most exquisite things in the world and we make exquisite products, but at some point quantity matters also. And I think you're also going to see us relearning the lessons of the exquisite thing that can do everything but you only have two of may not be what you need, particularly in some of these protracted or short time crises, right? Norm Augustine talked a lot about this consolidation. Eventually we'll consolidate from thousands of airplanes to one Death Star, and then with two bombs we'll drop it down and a missile tube and we're done. So we are relearning, I think, some of the lessons of the value of simplicity.

Danny Crichton:
Well, I think the DOD has done that. They have a lot of initiatives trying to go out to startups. In the intelligence committee of In-Q-Tel is trying to invest in a bunch of startups, get contracts going in. On the DOD side you have a bunch of different programs trying to get startups through the gauntlet there. But there's sort of two problems in my view. One is getting those programs of record getting into the kind of procurement flow. And the other one which I want to focus on today is sort of this capitalization problem, which is most VCs don't want to invest in the defense sector. Most people are looking at an oligopolistic market in which there are only a couple of buyers for these companies. And so if you build a defense tech company, you go to Raytheon, you go to the Northrop Grumman, there are only a couple of options of where to go.

And because of the kind of government procurement cycle, these companies do not have a lot of good multiples and they don't have a lot of leverage similar to banks. In the fintech world, if you're Plaid, it's very hard to sell to Goldman Sachs because you have a maybe 50 or 100 revenue multiple. Goldman Sachs is much lower than that and so they just don't have the ability to buy you. And so that gets to, I think, this part for Steve, I want to talk about why we need to shift the way we're capitalizing defense tech companies because right now it seems overweighted to the largest primes and massively underweighted to those kind of mid-market defense companies that are being innovative and nimble for solving a lot of America's problems.

Steve Carpenter:
In order to accomplish, I think, the goals of what Hondo is talking about in terms of national defense and security, you're by definition going to have to leverage a lot of the new technologies in order for those technologies to be deployed. Not only will they be sort of a traditional top-down enterprise by, which I think is what Hondo used to see within the military, now they have to be a much more bottoms-up product market-led where there's an actual specific use case that the defense industry can actually go out and procure.

Danny Crichton:
Well, I think once you're seeing this dual use category, right, which is in the commercial world, particularly let's say cyber is a great example, cyber attacks can target military websites and military infrastructure, but they can also target large companies. I mean, just as we're kind of recording the show this weekend, the LA Public School District, one of the largest, I think the second largest after New York, has had a massive cyber attack. Literally hundreds of thousands of students are not able to go to school. It's the first week of school, they have no access to grades. This weekend as well, the Japanese government lost several websites from a pro-Russian hacking group. And so it's one of these things where it can be government agencies, it can be commercial, but we all need the same products. And that was something that's very different than the old defense world where there's only one buyer for a Gerald R. Ford aircraft carrier and it's Hondo.

Hondo Geurts:
The shifting of the front lines is not on the battlefield. That's not the first place. The front lines have shifted. So like I said, this notion that we could separate national security, okay, that's a military problem, national prosperity, okay, that's a Wall Street, Silicon Valley problem. There are now kind of inextricably linked. And I think Steve brings a great point up, even in what you would consider a very old school capital-intensive, driven thing like a shipyard, you're going to see massive transformation if done right in the use of digital tools and the use of robotics. So again, separating, okay, well that's a Silicon Valley software company and this is a 200-year-old shipyard. If we're still thinking that years to come, then we are going to fail.

Danny Crichton:
Absolutely. So that gets back to the capitalization problems. So obviously there are dozens of new companies that are coming up that want to go and change this world to be nimble and rebuild the industrial base, but they have, in my view, a huge problem, which is no one knows what these companies are, who they are, what they do. They don't have names that are popular brand names. They're not a consumer out there you're going to install on your phone. And so they're never going to have that meme stock feel of Bed Bath & Beyond and AMC.

No one's ever heard of CrowdStrike popularly or whatever the case may be. And so that gets us to the index problem, which is I... Let's say I believe in this industrial-based theory and thesis, I believe it's going to grow. The front lines are shifting. We're going to have to play in multiple theaters, and that means I want to put some of my assets, whether retirement or personal investment assets towards that. How do I go invest in that? And Steve, it sounds like you have as a bit of a solution to that problem.

Steve Carpenter:
We do. At Thematic, we allow industry experts like Hondo to express their view of the market by creating very easily a basket of securities that in this case represent the next wave of security and technology for the United States. Hondo is clearly an expert in all things security and defense. He doesn't need to be an expert in how to create a stock index to express that view of the market. And so we partnered with Hondo and the team at Lux to create the next generation of the Lux security and technology index. So we're able to create a way for the public markets to track and then ultimately invest, rather than in these legacy four or five companies that have been referenced, a much broader basket of, in this case, 60 public companies that include CrowdStrike and Okta and CloudFlare and Ping and the next generation of companies that provide products and services that cover all of the different use cases that Hondo is referencing.

Hondo Geurts:
I think sometimes we think of this as an all or nothing affair. It's either all startups or it's all prime contractors, all... I mean, again, the DOD is $800 billion a year enterprise and an enterprise that is not going to boom or bust. The interesting thing about Uncle Sam is when things get bad, it orders more. I think what's intriguing to me about an index like this is it also recognizes it's not an all or none. It's not just all heavily weighted on the startup side or the mid-market side or the high end, big prime side. And so it really, I think, is a unique way to getting market perspective and understand the macro trends in that market sector as well as the full range of players that are impacting that sector.

Danny Crichton:
Well, I mean, this is one of theses for Thematic of building these sort of unique indices because I'm looking at iShares, the BlackRock ETF market, and I'm looking specifically at the iShares US Aerospace and Defense ETF, one of the popular ones in the defense category. And if you look at the weighting of the companies here, so Raytheon, 20.67%, Lockheed Martin, 16.06%, Boeing 7%, Northrop Grumman, almost 5%, you're seeing just the primes themselves are almost majority of the ETF itself.

So if you invest in the iShares aerospace and defense ETF, all that money is getting placed in a couple of companies, which are obviously the prime ones, but that's where it's balanced or biased maybe towards the past as opposed to the future. It's going to these sort of legacy prime contractors, which are obviously going to remain important, but you're not sort of getting that growth from a bunch of new companies and all these new multi-theaters where more investments should be made in order to create better defense.

Steve Carpenter:
When we were working with Hondo, we were specifically looking at a index that was much more broadly weighted, focused on the US and gave as much credit to companies that are in space like Planet Labs doing our infrastructure and security like a CloudFlare, CrowdStrike, Palantir. Those are companies that are just not going to be represented in the old traditional, much more heavily weighted indices and ETFs that you referenced.

Danny Crichton:
Well, interestingly, there's only 40 components to this one, which I think is also this narrow view of there's only a couple of companies that matter at the big industrial base, they have large factories and large shipyards. And that's sort of the extent of defense. And I think when we think of even just securities, I mean look at the name of the show. When we think about the definition of securities, I mean we're talking about space, cyber oceans, both land and sea and air. You're also talking about new networks where we've never actually had to deal with this before or cryptocurrencies where all of a sudden ransomware was empowered by this whole group of new technologies that came out of the last couple of years in blockchain and cryptocurrencies. And now there's a whole wave of companies that are trying to defend against those as well.

Hondo Geurts:
One of the challenges in the DOD is it's the largest research and development budget in the history of the DOD. I actually think that's a fail because there are plenty of ways, as you say, this index will help illuminate the funding, the capitalization on the front end. What the DOD needs to do is buy. It needs to get on the buying side of things and not squander precious resources, redeveloping what's already being developed in commercial markets or what could be developed in venture-based startups if they had confidence in the buy side of the market. And so I think this will also potentially help illuminate some of the trends going on for DOD decision makers. They can see where should they make their strategic investments and how do they better procure things more quickly to get them in the field to make a difference. Also help fuel the industrial base. This fund will help prime it, but it's got to be self-sustaining. And so I think that's what's also going to be interesting.

Danny Crichton:
Well, and you and I, Hondo, have talked about whether there's a Valley of Death for a lot of startups in the defense world, and I'm curious whether you still believe that there's no Valley of Death. If I recall, your view is that there is actually no way... The focus on the program of record is too much in Silicon Valley.

Hondo Geurts:
Yeah, I'm hopeful there's a growing trend of shifting from talking of program or record to capability of need. And so I think the government's got to get much more, "Here are the capabilities I need," not, "Here is the program-specific thing." And again, it's a big DOD market. In the Navy we would write 240,000 contracts a year. So I mean there's going to be some of each, but I think that's interesting.

If you look at Ukraine, you're seeing where commercially available, commercially developed technologies are having significant impacts on the battlefield. And I think that's also illuminating the opportunity in front of us that if we can figure out how to get these two communities to put strength against each other's weakness, and so now we're got strength on strength. That's how you're going to beat a China, centrally planned kind of economy. We don't want to try and out-China, China. We want to leverage the inherent strengths we have in our democracy and our financial marketplace and our dynamic workforce.

We've just got to figure out a way to connect the two ends so that we can do that. And again, just thinking about five or six primes is not the way we're going to do it. They're an important player, they're going to be an important player, but they're not the only players in this ecosystem if we're going to succeed.

Steve Carpenter:
So I thought you brought up a good point from both of you. Feels like as the risk assessment goes broader with software and the capabilities that are out there, it feels like the DOD can take more risks in terms of the applications and the software that it deploys.

Hondo Geurts:
You talked about in a nuclear submarine, I thought very differently about what was wet than what was dry. And on the nuclear reactor and on the whole, that's not where we're going to take risk and change every three months. But the AI algorithm on the acoustic sensors, trying to find targets, I could absolutely change those every three months. And in fact, the Navy's starting down that path. So we've got this idea of differentiating product differentiation and it's not just all or nothing, I think is really important. If we can get that concept working, we'll open up much more of the marketplace to leverage where we've got very high speed, highly dynamic performers.

Danny Crichton:
Well, I love this frame around capabilities. It's actually a piece I wrote that was actually one of my most popular pieces seven, eight months ago, which is around we invest in capabilities at Lux. And you mentioned Planet Labs, and I think of that as a canonical example of huge commercial opportunities when you can use satellites to scan the earth, you can use it for insurance. There's a bunch of different industries that needs the data. But then we just saw on the front page of the New York Times, I believe, this weekend, evidence around Ukraine focused on the nuclear power plant there that's under attack and being shelled by both Russians and Ukrainians. And so you have these capabilities where it's like it can be used in both cases, it's used for different modalities and it allows for iteration because you're learning from both the commercial sector and the defense sector simultaneously. They make both better. And Steve, I believe that is a component of the index.

Steve Carpenter:
Absolutely. So you mentioned at the beginning of our discussion about funding and growth. I think Hondo made a reference to the old primes are just very, very slow growers in the 4%. So as we were talking, I just pulled up the Lux security and tech index and I just sorted by enterprise value to revenue. And there are some very fast growing and quite valuable companies that in the traditional lens, but one, they would not be deployed by defense because they would never have passed all of the different loopholes in the budgetary constraints. But now they can be, and they can be deployed fairly quickly because it's software and different hardware components. So these are all of the different kinds of businesses that are getting access to those budgets and that never had the opportunity before. It's quite amazing actually.

Danny Crichton:
Well, I think it's also a sign that the Pentagon is getting serious about software. Because I think software has been the Trojan Horse to change a lot of this thinking around the industrial era. So long as you can build it, it's still going to go into a factory. It's still going to have that perception of you got to build the core base, you got to build a piece of hardware and then launch a piece of hardware. But it doesn't apply to software where there's much more of a flexibility around patching regular updates, which doesn't apply to an aircraft carrier.

You're not, as Hondo, just pointed out with nuclear submarines, you're not every three months updating the hull based on new technology. You're sort of locking it in for a program that might last decades in some cases. And so to me, it just shows that we have multiple modalities of way of thinking, and ultimately that makes a lot of sense. Different types of technologies need different ways of procurement, different ways of thinking about it, different metrics of success. In some cases, you're going to see a lot more commercially, whatever it's called, GOGO, GOCO, COGO, Hondo knows the acronyms. I'm so bad with acronyms, I try to avoid them.

Hondo Geurts:
My goal in this whole podcast is not to use this single acronym.

Danny Crichton:
I'm guilty.

Hondo Geurts:
You failed. You failed. One thing, if I could build on your comment, Danny, I don't want to make this all just because the Pentagon has certainly got... is suddenly enlightened or something. Quite frankly, what's really fascinating and gives me a sense of optimism are both the interest from large commercial players who are really focused on how do we bring the power of this marketplace to help the country and those folks serving in the country. And then I would say the growing number of Americans that feel deeply concerned about our national security and want to be part of a player to change it.

And so what's interesting to me is now we're seeing... Five years ago, that was not the feeling. Certainly not the feeling out in the valley was... And so now you've kind of seen a little bit of this awakening and everybody wants to do good. We've just got to figure out the mechanisms to allow folks to do good. But it's happening at the Pentagon, it's happening at the coffee house there in Palo Alto. It's happening in New York City. We've just got to create this connective tissue and ways to facilitate the good work that I think everybody really wants to go off and do.

Danny Crichton:
I think that's an amazing place to stop. Hondo, Steve, thank you so much for joining us today. Super appreciate it.

Steve Carpenter:
Thank you.

Danny Crichton:
Thank you so much for listening. Since we talked about ETFs and public stock trading, let's remind everyone that all investments are risky and nothing in this episode should be construed as an endorsement of any specific product for any individual listener. Always do your own research.