Defence and National Security landscape post COVID: portents for the private sector

Stewart Rendall, Associate Professor at the Australian National University and business executive recently provided Parbery with his thoughts on post Covid-19 implications for the Defence and National Security (DNS) Landscape. This is the first of a series of articles on this topic.

Article 1: Never let a disaster go to waste – how to prosper in rather than endure the post Covid-19 Defence and National Security Landscape: the portents for the private sector

Some 102 years ago, there were people giving talks relating to their optimistic future – post a truly devastating period of war and a devastating pandemic. Discussions held to consider the end of any great event leads to optimism and provides an opportunity to build a better future.

With a modicum of change, both the Defence and National Security organisations and the industry that serves, supplies, and supports it; can achieve great improvement – to the benefit of all concerned stakeholders.

My thinking in this has been guided by the following principle beliefs:

• we all learn more from mistakes than from success
• tragedy can lead to significant positive changes
• rarely do successful companies make massive changes
• small business is beautiful but so is big – each has its place
• it takes 66 days of changed behaviour to create a habit.

So, let us consider a more recent event, related to our industry, and identify if any good arose as a result of it and if so, how much and how long lasting were the changes.

9-11 was a tragic event which led to significant positive change in both the defence industry and government alike. As one example the 9/11 attacks drove “fundamental change” in the way the U.S. government uses and shares intelligence – integrating the military, intelligence community and law enforcement in ways that no-one would have expected.

‘Need to know’ was somewhat balanced, imperfectly, with a ‘need to share’. 9-11 drove fundamental change in hierarchical organisations that are usually resistant to change. Governments broke down many of these walls.

Prior to 9-11there was complete stove piping of intelligence in every organisation and 9/11 exposed significant vulnerabilities. After 9/11 people spoke of a need to connect the dots, but first of all, they had to collect these dots, then connect them – resulting in rapid improvements in secure, multi-level information sharing.

For example, New Jersey state police saved $1 million a week in overtime for officers responding to reported threats in an “unscientific way” using old fashioned fixed patrol zones and work shifts.

The automation of information sharing, and the National Information Exchange Model led to the creation of the now famous suspicious activity reporting (SAR) initiative.

All the pre 9/11 ills have not been righted, and the US sector is not perfect – far from it – but significant improvements have resulted.

What has all of this to do with Australian industry? In fact, critical solutions used to achieve the benefits described above were created by several Australian companies – and all the solutions had been designed and developed pre 9/11.

So, could events such as Covid19 be used as catalysts to fast-tracking fundamental change here in Australia and how can government assist in engineering an environment in which that can flourish?

And when one considers the above, it is reasonable to state that the Australian Defence and National Security industry sector, like many others, is truly perfectly poised to take advantage of this somewhat of a ‘once in a generation’ event.

Company strategy changes

Looking at the company strategy changes required to be undertaken by Australian industry to optimise the current situation, there are three main ‘outward looking’ lessons to be learned by every company serving the Australian DNS market. They are as follows:

1. Solutions – not just services
2. Export or perish, and
3. B2I is tomorrow’s B2G

I recently analysed the financial performance of more than 18 Defence and National Security industry companies listed on the ASX.  I reviewed the financial reports from these players over a period of years – and in particular:

• analysed elements of their performance;
• reviewed additional open source material from various countries;
• used material from Australian Defence related media recent publications to compare the numbers; and
• conducted a number of conversations with individuals in both government and industry.

The following are my initial findings…

1. the most profitable, and the fastest revenue growing firms sell solutions – ‘build once, sell many times’ offerings
2. the least profitable and slowest growing only sell services
3. those companies with high export sales – had the highest revenue increases
4. the companies with strongest export strategies attracted the greatest capitalisation – in other words, confidence in the future
5. and finally, ‘exit strategy’ options are significantly increased, and higher prices paid when one is a solutions company – be the options a trade sale, an IPO, MBO or merger with another company.

As examples, I reviewed several of the more prominent firms in this category including:

CEA Technologies – a famous Canberra company. With a turnover of $126m, CEA exports $25m pa – approximately 20%

EOS – grown from approximately $20m pa in 2017 to more than $160m in 2019. Exports, according to Australian Defence Magazine (ADM) are 98% of revenue.

Appen – although Sydney based Appen is not necessarily viewed as a pure DNS ‘player’ its solutions are used by all Five Eyes. Their half year results of more than $300m relied very heavily on their solutions sales into export markets.

ArchTIS – successful IPO in 2019, realised that services alone were not the future path to growth and profitability.

Marand – private company – 91% of its $90m turnover are exports.

XTEK – FY2019 – turnover $42.7m net profit $302k (and a quote from the XTEK site) “Future margins are expected to increase, underpinned by a shift to products”.

One of the main reasons as to why services appear to be attractive to companies in their formative days is that of less perceived risk. I know of a number of companies where the founders moved from being in the Australian Public Service on a Friday to opening a services company on the following Monday.

Through personal experience, I am also well aware of how relatively straightforward the process is to transform from services to solutions, but companies must be prepared to make one large fundamental change; that is to change their risk profile. Solutions require ‘up-front’ investment and funds sourced normally from one or more of three sources – investing from existing profits, raising equity capital, debt, or on some occasions, even receiving government grants.

The time is right … now!

The two key elements to foster a shift to solutions are both in abundance at present:

1. the corporate cultural environment is right, and
2. the fundamental costs structures are at an all-time low.

The corporate cultural environment is the result of Covid19 changing the way we view the fundamentals of tolerating change, measuring risk and identifying opportunity. The market is wide open to change. In fact, it is hungry for new ideas and solutions.

From a cost perspective, the cost of funds and equity has never been more affordable. If a company has retained earnings, now is the time to invest in itself as the return on funds invested ‘in the bank’ are so low.

Debt has never been cheaper – who would have believed that at a time like now, mortgages are available at less than 2%. This is an excellent time to borrow. An advisory client of mine recently took out a business loan with one of the major Australian banks at 3% to invest in plant and machinery – an extraordinarily low rate.

In terms of equity capital, there is an enormous pool of money – from super funds to retail investors all looking for stable, high-growth, revenue returns – and there is nothing quite as stable as a Business to Government (B2G) company. Importantly, there are no borders when it comes to raising equity capital – the USA remaining as usual as the single largest source. It would be an error for Australian companies to confuse the Australian physical border with the financial border.

To validate the above, I created a target for myself and some of my ANU students at the start of the current Semester to not only teach the subject ‘New Venture Creation’ but also identify and assist the students to actually raise capital whilst still studying in class. I am more than pleased to advise that 3 of these ‘new ventures’ have already raised capital and one venture has sourced in excess of $100,000 in start-up funds. In addition, one major reason why companies should develop solutions rather than simply deliver services is that it offers companies a much larger number of options when it comes to considering an exit strategy.

Throughout my career, I have witnessed numerous Australian services companies become highly successful, but the founders rarely maximise their benefits when it comes time to ‘exit’ as the value of the company remains with the founders themselves.

Many of these firms simply ‘faded away’. Services led organisations find it difficult to maximise their value if key people leave, the services streams can then collapse and thus the investment value.

Solutions based companies can offer a larger number of options and avenues in terms of exit – from trade sales, to Initial Public Offerings to Management Buyout, etc. Like a good cheese or a malt whisky, solutions companies can age better.

The importance of exporting

Turning our attention a little more to exporting, the true value provided to an organisation by international business is not simply an increase in overseas revenue, but the resultant increase in domestic revenue as an organisations’ credibility is significantly enhanced when it can win overseas contracts.

Successful exporters, like migratory birds and whales, head north in winter – and I do not mean Queensland – they head to Europe and North America.

At its simplest, the size of the markets overseas simply dwarf the Australian Defence and National Security Sector:

• USA – government spends approx. USD904bn per annum in this sector
• Europe – spends approx. USD282bn per annum
• Australia – approx. AUD27bn (USD19bn) per annum or 2% of the US figure.

To provide some context to the above figures – the most exciting and also the most depressing journey I have taken in my long career in exporting is the one taken, late in the evening after a long flight from Australia between Washington Dulles airport heading downtown through the suburbs of Reston, Tysons Corner and Falls Church.

The exciting part is that each company with naming rights on the buildings that line Virginia Route 267 are both potential sales opportunities as well as being potential competitors. Each building is large and imposing but the scariest part is that each building is not the global HQ of these companies but simply one of the myriad of government focussed offices for these large corporations.

In two companies I have led, we had to be successful in Reston before we became big in Russell.

If, however, companies and particularly SMEs, are going to be serious, it is essential that they treat exporting in the same way as they consider other ‘risk capital’ such as product development. This means they need to invest an appropriate amount of funds, staff it appropriately and accept that the first people sent overseas from Head Office here in Australia will be on planes and in meetings for quite some time. There are no easy ways … but it is a tried and tested process to be successful.

There is no magic ‘pixie dust’ to selling in overseas markets – it takes time, hard work, dedication, resilience, and most importantly trust and relationships. It is, however, no more complex, or complicated to succeed overseas than in the Australian Defence and National Security market … with the prospect of significantly larger returns.

One Return on Investment (ROI) example – again from personal experience, and on a tangible and measurable basis, for every dollar invested in the US market, my ex-company’s Return On Investment per AUD1 was AUD9.20, the ROI in the UK was AUD6.70 and the ROI in Australia was AUD3.90.

In addition, even small issues are easier to create and maintain. I remember having to sign every page of an ASDEFCON contract comprising 3 x 75mm D ring binders. We were simply a subcontractor, but the Prime had decided that all clauses were to flow down to the sub-contractors. The value of the contract to our company – $3m.

By comparison, the US government created a simplified version of a contract which was 42 pages long and required a single signature on the last page – and this was valued at more than $10m.

One word of caution, however – being an exporter is much more than simply selling things overseas. To create a sustainable, successful, export business requires the creation of an organisation that is fundamentally global in mindset. Too many companies adopt a ‘piecemeal’ approach which rarely results in sustainable success.

Critical Infrastructure – the next big thing

Finally, looking forward it is important to understand and benefit from the realisation that B2I (Business to Infrastructure) is tomorrow’s B2G.

Existing companies in the B2G sector, in an effort to de-risk (that is to mitigate the ‘valley of death’ conundrum facing many Defence and National Security industry players) need to ensure that they expand into related and complementary sectors.

The amount of funds currently being spent in protecting critical national infrastructure is approximately USD100bn (source – Globe).

Critical National Infrastructure organisations demonstrate many of the key facets and attributes of the Defence and National Security market. They tend to be quasi-government in nature, large in size, initially slow to move but loyal in the medium to long-term and seek guidance and assistance to implement across states and on many occasions across the country – and they also want Defence grade solutions as they are, on many occasions, a target of foreign entities.

Critical National Infrastructure organisations are a perfect ‘fit’ for the DNS industry as they seek confidence, value experience, trust, and a track record and the assurances aligned and associated with those more commonly found in the DNS sector.