Can the Defense Industry Unkink Supply Chains to Meet Demands?

Manufacturers are grappling with inflation, supply chain kinks, and labor shortages to rebuild the domestic arsenal

Russia's war on Ukraine has created demand for increased defense production in the U.S. to replace items withdrawn from its domestic stockpile and to sell to nations intent on increasing their own security.

Take the M142 high-mobility artillery rocket system (HIMARS) rocket and missile launcher, a five-ton truck that can fire long-range guided rockets. The United States has sent at least 16 of them to Ukraine.

"We know we have to replenish some of the ones we’ve provided, but we also know that foreign military sale requests are coming in for them, too," said the Pentagon's chief buyer William LaPlante, undersecretary of defense for acquisition and sustainment, in a September press conference.

Ordinarily, requests for more armaments from American manufacturers would be seen as a good thing. At this time, however, domestic producers are grappling with inflation, supply chain kinks, and related issues, including labor shortages and shrinkage in the defense industrial ecosystem.

Prior to Feb. 24, when Russia made its most recent incursion into neighboring Ukraine, global security was in a relatively benign state, Lockheed Martin CEO Jim Taiclet, who is also chairman and president of the company, said on a Q2 earnings call with investors in July. The U.S. had withdrawn military operations from the Middle East after 20 years. China's activism in the Western Pacific was a watch item for the future. Europe was at peace and Russian forces remained at home.

"For the next couple of years, we were expecting relatively flat defense budgets in the U.S., not a lot of concern out in the allies," Taiclet opined on the call. "That's all changed. There's a demand signal out there that's clear. There's funding appropriated by the U.S. Congress in the case of the United States."

Given the lengthy process governments must go through for such acquisitions, which are even longer for foreign powers who must get the go-ahead from Washington to buy domestic armaments, the manufacturers have several years to work on their supply chains and hire more workers. There's pressure to replenish U.S. stockpiles sooner than that, but Taiclet said he doesn't have a clear picture on that situation yet.

"We’re supporting it, of course, and making sure they understand what the capacity capabilities are over the next two, three years to get up to higher volumes," he said. "But those actual decisions on timing and budgets will come from the services and the Department of Defense and through the administration. So we can't really comment on the specifics of that. We do expect it to come, though."

What was unexpected for some was shrinkage in the defense industrial ecosystem.

The defense industrial base faces an ecosystem challenge due to fewer new market entrants—a smaller quantity and spread of small- and mid-sized businesses— and a burgeoning skilled workforce crisis, according to the National Defense Industrial Association (NDIA).

In the NDIA's Vital Signs 2022 survey, almost one-third of industry respondents self-identified as a "sole eligible supplier," each representing a single point of failure for U.S. defense supply chains. Industry also relies heavily on international sources for its manufacturing capacity. Over-reliance on these sources can increase supply chain fragility, which was starkly shown with the microchip shortages.

In addition, the annual number of new vendor companies in 2020 fell 28 percent since 2018, according to NDIA. New vendors are a key part of the defense supply chain as they provide innovation, redundancy, and new capacity. Concurrently, companies are leaving the defense sector at an alarming rate, with 20 percent of total vendors exiting over the past five years.

"There has definitely been a consolidation and disappearing in the defense supplier base," noted lawyer David Gallacher, who specializes in public contracts, supply chain management, and litigation at Sheppard Mullin Richter & Hampton LLP (Washington, D.C.). He cited three key factors driving the shrinking market: A massive regulatory burden, bankruptcy, and mergers and acquisitions (M&A).

The bankruptcies are driven by shaky financial conditions created by the COVID pandemic, he said, with some companies unable to weather the economic upheaval. Both bankruptcies and the M&A activity are prompted by a number of market conditions that remain through 2022, Gallacher added.

Even so, the defense industry may have fared better than other sectors due to federal intervention.

"Congress did a lot and the federal government tried to do a lot," Gallacher pointed out. "And in the defense industry, there was an opportunity to funnel direct money to contractors. It was not your classic trickle-down money model like what we saw with the stimulus efforts in 2009," he continued. "Here the federal government was able to get money more directly where it needed to go. That probably actually helped the defense industrial base weather the crisis a little bit better than other industries."

The industry also benefited from programs like the paycheck protection program that helped maintain workforces. Nevertheless, just about everybody had to tighten their belts and suffer through the pandemic, Gallacher lamented, "No one was unscathed."

What the crisis did fairly efficiently was separate the weak from the strong. Many of the companies positioned to do well before COVID, especially those with improved cash flow going in, came through pretty well, Gallacher said.

"My sense is that, especially with automation and a little understanding, many of the manufacturing schedules stretched, but they didn't necessarily break, through COVID," Gallacher reasoned. "I think most companies—as well as their customers—made peace with the fact that deliveries were going to take a little bit longer, while still recognizing that the supply chain was not necessarily irretrievably broken."

The government entity responsible for acquisitions for the military, the Defense Logistics Agency, attributes the shrinkage of the supply base to "reduced competition due to mergers, labor shortages, lack of tradesmen skilled in aging aircraft, and probably the biggest contributing factor of late is the supply chain issues really hitting hard on the smaller suppliers that were unable to withstand the impacts," said DLA spokeswoman Michelle McCaskill. "Another factor could be the inherent challenges of supporting legacy systems. There simply isn't the same or consistent level of demand needed to support a robust industrial base."

DLA has had to change and adapt its mindset and strategy at managing its defense industrial base. "Like many organizations, DLA is working on supplier illumination to ensure we are laser-focused on what may affect us when world events such as pandemics or conflicts such as in Ukraine happen," McCaskill said.

The agency surveys its 7,000 suppliers every two years and is growing its market intelligence program to glean vital information needed to counteract suppliers leaving, according to McCaskill.

Compounding supply chain problems are U.S. raw materials sourced from Russia, some of which are subject to new tariffs or a changing financial infrastructure subject to change. Titanium, for example, is one of the most commonly used metals for military applications. It's also used in commercial aviation manufacturing.

Russia is the world's third-largest producer of titanium sponge, the stage between the raw mineral and finished metal, with 13 percent of the market, according to Reuters.

Among those working to secure new sources of titanium are Raytheon Technologies Corp. and its aircraft engine-making business unit, Pratt & Whitney.

"We don't have the titanium forgings that we had expected to get this year," said CEO Greg Hayes, who is also Raytheon's chairman, in a July 26 Q2 earnings call. "This will recover sometime in the middle of next year, but there's still a lot of work to do to get these suppliers qualified."

Hayes also noted bottlenecks in procuring microelectronics and rocket motors. He thinks non-Russian titanium suppliers see the situation as a big opportunity to gain market share, and are stepping up to fill the gap. Even so, he cautioned, there will be delays.

"The issue is simply getting the parts qualified," said Hayes. "You’ve got to go through a first article. You’ve got to go through the metallurgical analysis. You’ve got to make sure that the composition of material is exactly the same as what it was prior. And then you’ve got to get the parts certified (by the Federal Aviation Administration). So that's the part that takes time. It's not actually identifying the suppliers. We’ve done that."

Raytheon is doing deep dive reviews on its supply chain, examining the list supplier by supplier. This includes qualifying second, and in some cases, third sources for critical parts as necessary, according to Hayes. The company also has people embedded at about 330 of its suppliers to help improve performance.

"It is pick-and-shovel work, and it's also about trying to make sure they’ve got the right labor—trained labor—to get all this done," Hayes said. "So it is a hill to climb in the back half of the year, and it is a challenge that we’re going to have to take out in order to meet our customer demands or our customer needs. I mean, this is really about making sure we can deliver to our customers on time. And right now, we’re suffering." The company's answer to mitigate challenges in the supply chain, inflation, and labor availability is to focus on cost reduction and operational excellence, Hayes said.

Deep dives into supplier ranks might strike a nerve with the Pentagon's LaPlante. At his press conference in September, he said, "I had a CEO of a company tell me that he thought he had 300 suppliers. Then he discovered no, when he counted all of his suppliers, he probably had 3,000 suppliers. And suppliers can change overnight."

The anecdote points out that keeping tabs on suppliers almost calls for real-time tracking, or "supply chain illumination," to ensure a company's supply chain is intact.

"The good news is there are tools coming out using artificial intelligence and open source that can dive in and maybe find some of these things, but I think it's going to be a constant—a constant issue for us, is—is understanding our supply chain," LaPlante acknowledged.

Boeing Co. also is experiencing "real constraints" in its supply chain. As a result, the company is working to mitigate risk in a number of areas, including engines, raw materials, and semiconductors, said Brian West, executive vice president and chief financial officer, during a July earnings call.

To counter the problem, West said, Boeing is planning a multi-pronged strategy. "To stabilize production and support our supply chain, we’re increasing our on-site presence at suppliers, creating teams of experts to address industrywide shortages, utilizing internal fabrication for search capacity and managing inventory safety stock levels, and growing where needed."

News reports have said Boeing voluntarily cut off supplies of titanium and aluminum from Russia.

General Dynamics Corp., Reston, Va., expects that "By 2024 and beyond, we ought to see a nice uptick trajectory in combat systems," said Jason Aiken, the company's senior vice president and chief financial officer, on a Q2 earnings call in late July.

"I think the key thing that we all have to keep in mind here is to keep in check our expectations with respect to timing," Aiken added. "The demand signals are there. We are having regular dialogue and ongoing conversation with those customers about that interest. But it just takes time for interest to turn into budgets, to turn it into appropriations, to turn into contracts, to turn into revenue."

General Dynamics Land Systems, a business unit of General Dynamics, has a multi-billion-dollar pending order from Poland for 250 Land Systems-manufactured M1A2SEPv3 Abrams tanks. The order, which came in 2021, was cleared by the State Department earlier this year.

As plans and orders are sorted out, the defense contractors are still reeling from effects of the pandemic and, whether COVID-related or not, difficulties filling worker slots.

Raytheon's Hayes said the company is suffering from unexpected, trickle-down after-effects of layoffs during the downturn at the start of the pandemic.

"Typically, we get about 75- to 80-percent of those folks come back off of layoff," he said. "In this case, what we’re seeing in our supply chain is only about 25 percent of the people are coming back. They have found other jobs, similar jobs. Again, because the labor market is so tight in this country, we just don't have a large pool of resources."

Hayes is confident his company can deal with its own labor shortages because of its good pay and competitive benefits. People hire on at Raytheon because of its mission, he said, which is a differentiator for the company in the marketplace.

"The hope, of course, is as we see the economy slow down here in the coming months and perhaps year, that we’ll have the opportunity to continue to drive more folks into both the shop floor as well as into our offices on these programs," Hayes said. "But as you go down into the second-, third-, and fourth-tier of the supply chain, they are struggling to attract workers.

"I think the only thing that's going to solve labor availability, I hate to say this, is a slowdown in the economy because right now, there just simply aren't enough people in the workforce for all of our suppliers."

Raytheon's intelligence and space business, one of four segments that make up the conglomerate, is having trouble hiring engineers and personnel with security clearances.

"If you look at the unemployment rate for engineering talent in the U.S., it's less than 2 percent," Hayes said. "We started the year with a goal of hiring about 2,000 engineers net of attrition, which means we have to hire probably more than 5,000, and we are struggling in that regard as well. And again, you don't think about it, but engineers working on programs generate revenue.

And so, as we think about the issues in Q2 and really the first half of the year, we have seen the supply chain but also a labor availability impact our defense businesses."

"Labor has been an ongoing challenge, I think, for the industry, as well as us," attested Jay Malave, chief financial officer, Lockheed Martin. "I think given the size and the scale of Lockheed Martin, I think that we’ve been able to weather it reasonably well."

For example, Lockheed took close to 50 employees out of an international operation and brought them to Greenville, S.C., to help the company move quicker on its F-16 program, he said. All the while, the company is "laser focused" on hiring and has a dedicated human resources team on recruitment.

"So it just goes to the strength and the breadth that we have here at Lockheed Martin," Malave declared. "But nonetheless, it's been a challenge. Our ramp on that program is taking longer than we had originally anticipated largely because of the slower ramp in hiring employees."

At General Dynamics Information Technology, Aiken called it a daily war for talent. "Obviously, they are in a hyper-competitive market for hyper-skilled talent, and that only gets more competitive all the time," he said. "I think the leading positions they have in their markets, the strong culture they have and continue to build with that workforce, and the opportunities that they provide their workforce within the company continue to, I think, put them in a good position to compete and keep and grow that talent.

"It's our job to keep up with that and punch above our weight and continue to retain and draw in the kind of talent they need to do that work and as that business grows," Aiken said.

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