US, European armsmakers adapt to surge in defense budgets

Armsmaking operates distinctly from other industries, being insulated from macroeconomic fluctuations and changing consumer preferences.

Its success relies entirely on the perceived military threat level faced by its government clients. With ongoing conflicts in Ukraine and Gaza, potential war between Israel and Lebanon, and tensions over Taiwan, the threat perception among NATO leaders, meeting in Washington from July 9-11, is extremely high, according to The Economist.

Last year, NATO’s 32 members spent a record $1.3 trillion on defence, the highest since the Soviet Union's fall, adjusted for inflation. The U.S., as the largest spender, allocated $842 billion for this year. Historically less inclined towards heavy military spending, European nations are now reversing decades of underinvestment due to Russian aggression, addressing an estimated $600 billion equipment shortfall. NATO expects 18 members to meet the 2% GDP defence spending target this year, up from just three in 2014.

Although not all defence funds go towards equipment—with salaries, base maintenance, and gear upkeep also requiring funds—28% of NATO’s collective defence budget last year, around $360 billion, was spent on weapons systems and major equipment. This is double the amount from a decade ago and is expected to continue growing. Charles Woodburn, CEO of BAE Systems, which manufactures the Typhoon fighter, predicts “a long runway of increased defence spending.”

This should herald a boom for American "prime" contractors like Lockheed Martin, RTX, and Northrop Grumman, which are central to the military-industrial complex and dominate sales compared to their European rivals. The Pentagon’s $315 billion procurement and research budget this year will largely benefit these American firms, with Lockheed alone reporting $68 billion in sales last year.

Despite this, American defence executives are notably restrained. Since Russia’s invasion of Ukraine in February 2022, the market values of firms like Lockheed, RTX, and Northrop have barely risen, underperforming compared to the S&P 500 index. In contrast, European counterparts have surged, with Thales of France up 86%, BAE doubling, and Rheinmetall of Germany quintupled. The valuation gap between American and European armsmakers has narrowed.

One reason is that American firms are stretched thin. After the Cold War, Western defence budgets shrank, procurement decisions were delayed, and production scaled back. Post-9/11, America's focus shifted to counterterrorism, reducing the emphasis on hardware manufacturing. China's naval assertiveness in the Pacific further shifted America’s strategic focus away from land systems like armoured vehicles. Thus, there was no capacity increase to support a ground war in Europe.

Restoring this capacity will take years and requires assurances of sustained demand. As Woodburn notes, defence firms need a “reasonable business case to put the balance-sheet to work,” a case currently clearer in Europe than in America. BAE, for instance, secured a deal last year to replenish British artillery stock, and Rheinmetall recently won a significant munitions contract from the German government.

Meanwhile, America’s already vast defence budget is barely growing. A fiscal-responsibility law may freeze real-term spending until 2033, with procurement and R&D expected to decline next year. Northrop Grumman’s CEO, Kathy Warden, warned of “slower top-line growth” in American defence spending. Last year, Lockheed’s sales grew only 0.8% nominally, potentially falling by one-seventh after inflation adjustment.

Changes in Pentagon procurement practices also pose challenges for prime contractors. The Department of Defence (DoD) is shifting from cost-plus deals, which capped production profits but covered R&D costs, to fixed-price contracts, which pose greater risks of cost overruns. This shift has led firms like Northrop and Boeing to incur significant losses. Lockheed’s CEO, Jim Taiclet, announced that the company no longer has “any must-win programs” due to the risk of over-optimistic bids.

Additionally, the DoD’s focus on nimble smart systems over traditional heavy equipment has introduced competition from newer defence firms. Companies like Anduril, which specializes in autonomous drones and software-driven systems, are now viable competitors. Anduril’s CEO, Palmer Luckey, notes that the Pentagon is embracing "non-traditional" defence firms, contrasting his company’s agility with the "cost-irresponsible" primes. Anduril’s significant win came in April when, alongside General Atomics, it defeated established giants like Boeing, Lockheed Martin, and Northrop Grumman for a contract to develop a self-flying plane for the Air Force.

While the primes still dominate in complex systems like aircraft carriers and submarines and benefit from increasing foreign sales, they face growing competition and a changing procurement landscape. They may benefit from potential increases in American defence budgets, especially through supplementary appropriations or political changes, but they must adapt to the evolving defence market dynamics.