Uncertain Times and Uncertain Customers

Good morning and we hope everyone had a great Mother’s Day Weekend! We have started to hear rumblings from concerned investors about the debt ceiling debate.

Let’s get to it:

• 🔥 Political brinksmanship

• 💰 The Term Sheet

• 🤔 ChatGPT takes a stab at defining DoD customers

• 🚩 Red Team Update

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Debt Ceiling Political Brinkmanship - Impact on Defense

Uncertainty surrounding the debt ceiling raise is worrying defense investors due to the potential short- and long-term impacts on government spending

Investors hate uncertainty. Right now, two potential outcomes exist:

1. (Worst Case) The US defaults on its debt obligations and the credit agencies downgrade the US, causing unknown amounts of instability in the financial system. Goldman Sachs has estimated it could cost the country as much as 10% of GDP if the US does not raise the debt ceiling and prioritizes funding to debt obligations

2. (Most Likely) The budget is delayed due to an extension and the Pentagon operates under an extended continuing resolution (CR), which restricts new programs and contract awards

• The good news, the market is only pricing in a ~1% chance of the US defaulting on its debt obligations (the bad news, the chance of default is typically way lower, around ~0.15%, the cost of a credit default swap (CDS) one year ago)

• For info on credit default swaps and the probability that something most likely will not happen, watch this clip

• Defense sector investors are concerned with both outcomes of the debate because military defense spending could be outright cut or, most likely, the budget could be delayed

One way to measure current investor appetite for defense-focused investments is by comparing the performance of the defense primes to that of the S&P 500

• Defense stocks have been under pressure recently with Lockheed Martin (LMT) down roughly 7% year-to-date (YTD) and General Dynamics (GD), Northrop Grumman (NOC) and Huntington Ingalls (HII) all down double digits vs. the S&P 500, gaining 8% YTD

• The selloff has been accelerating in the last month and some of the names are down to levels not seen since before Russia’s invasion of Ukraine

• If no deal is made to raise the debt ceiling, the primes will most likely deal with cash flow issues if the US government prioritizes debt obligations and other expenses over paying defense contractors

The situation would be even worse for defense tech startups and early stage companies relying on government spending

• CRs are nothing new for DoD, but the CR outcome (most likely) affects any company that is relying on future revenues from awarded contracts and can stifle defense tech innovation or building the Arsenal of Tomorrow 

• A prolonged stalemate could result in a freeze of government spending, making it challenging for these startups to secure contracts, attract investors, and access vital venture capital

• Similar to large cap defense investors, venture capitalists may shy away from backing defense startups due to the uncertain government funding landscape

Last week, Palmer Luckey, founder and CEO of Anduril, an $8.4B defense tech startup, stated in an interview with Morgan Brennan on CNBC:

The political brinkmanship is not just about paying the government’s bills today - it has effects far into the future, especially with early stage defense

• It is crucial for policymakers to address this issue promptly, recognizing the vital role defense innovation plays in the US’ technological edge to thwart conflict with adversaries

• President Biden and Speaker McCarthy are meeting later today to discuss the debt ceiling

• Here’s hoping the uncertainty is resolved soon, since even a deadline extension would cause significant disruption

Defense Entrepreneurship 101: Your Customer Isn’t the End-User in DoD

“Who is the customer in DoD acquisitions?” - AoT

“While the customer is not a single person, it is important to note that the customer's needs and requirements are driven by the needs of the end-users, who are often military personnel or other government agencies.” - ChatGPT

Like any startup should, we start with a simple question: who is your customer when you sell to DoD? We don’t get a simple answer. As the leading quote implies, the customer is not always the same as the end-user. In fact, the end-user might be called the beneficiary of technology that the DoD purchases, but it’s at best misleading and at worst flat-out wrong to call the end-user the customer. A customer usually has choices; the DoD end-user does not.

This is somewhat like the classic dual-agency problem, with a twist: the capability development system simultaneously represents the DoD as a “buyer” while representing the end-user as (the only possible) “seller” (shoutout to a reader for nicely articulating this conundrum - drop us a line here!). This results in:

• a system that becomes difficult for commercial entities to do business with because it spends a disproportionate amount of time on the buyer side 

• why? a mistaken assumption that more policies, touchpoints, processes, and hierarchy will somehow deliver greater value

• more emphasis should be placed on the seller side by ruthlessly focusing on value - not value as “good deals,” but value defined as anything important or worthwhile to the end user

Identifying value isn’t wholly absent from the capability development process. Broadly, the DoD:

• finds and sets requirements (Joint Capabilities Integration and Development System, JCIDS)

• plans to pay and pays to get them met (Planning, Programming, Budgeting, and Execution, PPB&E)

• procures technology to meet theme (Defense Acquisition System, DAS)

JCIDS is where end-user requirements are ostensibly captured, but this process is usually managed by senior personnel with end-user experience that may suffer from obsolescence, increasingly so dependent upon the type of technology being developed. And The System tends to satiate itself by abstracting away the real and specific needs of end users by generically promising value to “the Warfighter,” who is hardly ever defined. If you’re selling to DoD, you’re probably dealing with DAS or maybe RDT&E (which we covered previously here).

But you’re probably not dealing with an end-user (ahem, Warfighter) directly, and if you are, that’s not actually the person you must sell to.

If not the end-user, then who? It depends. A good way to answer this is with another question: “who makes the choice?” That entity is most nearly the actual customer, but who or what that is depends on context. It could be:

• a contracting officer (only these can enter into contracts on behalf of the federal government, btw)

• a technology expert advocate

• a program manager

• a requirements generator

• an ad hoc committee

• someone else

This is why well-entrenched primes have such robust business development networks and is a main disadvantage for smaller firms or non-traditionals in securing customers, leading many to find a subcontractor strategy more appealing. It’s also why it’s so different from many commercial industries where the power of choice usually means the customer is the end-user.

The focus here isn’t on how to dissect and modify aspects of a hugely interconnected and complex system, but to remind you of the critical importance in identifying your customer. It’s as important in DoD as it is in a startup, but the answer is usually a complex web of stakeholder mapping and not actually the person using your product.

When dealing with DoD, the product should always be developed for (and ideally with) the end-user, but it’s never sold to them.

Developing new technology is usually the easier part; finding and selling to the right buyer(s) is the difficult part.

Red Team Update

China’s Messaging Machine Tamps Down Taiwan War Hype

• A notable change is occurring on the internet in China, where a ban on discussing the forced unification of Taiwan appears to have been lifted, allowing contrarian views to emerge

• There is a growing recognition among the Chinese that forcibly unifying Taiwan would be unrealistic and dangerous. Anonymously written articles rejecting China's aggressive diplomacy have been circulating online, highlighting the likelihood of China facing multiple fronts if it chooses to use force. (US, South Korea, Japan, India - the 4 fronts)

Why China Has the Edge on AI (The Harvard Gazette)

• In a US government ranking of companies producing the most accurate facial recognition technology - the top five were Chinese companies

• Autocratic regimes collect vast troves of data which advantages companies with government contracts, who can use state data to bolster commercial projects

Russia’s Ministry of Defense is Too Slow at Building an Arsenal of Tomorrow

• Russian Telegram took notice of a Ukrainian Uncrewed Underwater Vehicle and lamented that the MOD was too slow at developing new tech and capabilities (sounds familiar?)

• Sam Bendett of the Center for Naval Analyses reports that the Russian Telegram notes how the MOD is still very far from giving freedom to Russian engineering teams for accelerated combat testing and the adoption of initiative developments for service

• In contrast, Ukraine has quickly gained a reputation for innovation and ingenuity as they are faced with an ongoing invading aggressor, Russia

About Us

Our team has 30+ years of combined experience as military officers using the end products. We’ve worked in both government and industry. From MIT to Wharton, Wall Street to biotech, and DARPA to the flightline, we will offer you a unique perspective on how to navigate America’s defense tech industry.

The opinions expressed in this newsletter are solely those of the authors and do not necessarily reflect the views of DoD, our employers or any affiliated organization. This newsletter is for informational purposes only and is not intended to provide legal, financial or professional advice.