Why European defense is at a crossroads

The European defense industry needs to adapt quickly to a new global security environment.

In brief

• Four new drivers are fundamentally changing assumptions that have shaped the industry for at least a decade.
• European defense executives should consider five key areas to navigate the complex landscape of a changing world.

Countries around the world were quick to provide military support to Ukraine when the war began in that country in February 2022.  As the conflict continues, the commitment to provide military assistance has remained solid. However, in order to produce and deliver what’s needed, the European defense industry needs to evolve quickly.

Key assumptions that have underpinned national security policy and business strategy in the defense sector have been shaken, or no longer apply. The demand for defense capability and the budget to provide it are growing fast; stockpiles of existing materiel are running low; new technologies are emerging; and battlefield needs are changing.

There are some key factors that are reshaping the defense industry and creating new actions for business leaders to consider now, so they can stay ahead of change.

1. The focus of defense policy is changing

North Atlantic Treaty Organization (NATO) countries have responded to the war in Ukraine with financial aid, security assistance and materiel – either to Ukraine itself or to other NATO members. Additionally, there has been a large-scale US provision of stockpiled ammunition and new equipment, such as tanks, complemented by European NATO countries exploiting their existing stocks.

The extent of this support means that many European NATO countries are now incapable of providing sustained material aid to Ukraine while also maintaining a credible national response to security concerns. This is because a long period of perceived low threat levels before the war resulted in sustained underinvestment by NATO countries.

Not surprisingly, the NATO countries most concerned about events in Ukraine are its Eastern Core members. For them, security policy and spending are higher priorities than in the Western Core. This could lead to a change in the locus of security policy in Europe, with a shift from western and central Europe to eastern Europe, including the Baltics and the Nordic countries that are currently in discussion to join NATO.

A shift to the east would be a shift away from Europe’s industrial core, which would test the historical underpinning of defense trade in the region. As eastern countries spend more on military equipment, they may have to look for suppliers beyond western Europe, where production capacity is constrained. Poland recently purchased tanks from South Korea demonstrating a shift to suppliers outside of Europe.

Can traditional but under-spending partners from western Europe fulfill eastern Europe’s urgent defense needs? If not, the western European defense industry risks losing revenues from initial equipment purchases and recurring revenues, such as maintenance.

Source: NATO, SIPRI, OECD, EY Analysis

2. Defense spending will continue to grow rapidly

Source: SIPRI, OECD, EY Analysis

Regional defense spending will continue to increase as countries invest to meet new demands. NATO countries each have a national commitment to achieve their own strategic aims, particularly in eastern Europe: they need to replenish the stocks they have used to support Ukraine; they need to support NATO’s desire to increase operational readiness in eastern Europe; and they need to respond to high levels of inflation that are rapidly eroding their defense purchasing power.

However, there has long been a stark difference between how much NATO’s eastern European members have spent on defense compared to their partners in the west. Many countries in the west have been unwilling to spend 2% of their gross domestic product (GDP) on defense, which is the target level NATO expects. By contrast, eastern European governments are spending almost 1% more of their GDP on defense than their larger, more prosperous western European neighbors.

Military expenditure forecast in core countries 2021-25 (in US$b)

Source: SIPRI, OECD, NATO, EY Analysis

With a war in Europe, attitudes around defense spending have changed. Several of the NATO countries that are already above the 2% threshold plan to spend even more, and under-spending countries have said they will close the spending gap to the GDP threshold. Spending is projected to grow between 18% and 66% over the next 3-4 years, resulting in significant industry-wide transformations.

If these promises are met, the impact on total defense spending would be profound. One scenario indicates there could be as much as US$200b in additional defense spending over the next four years, if underspending countries within NATO’s core countries reach 2% of GDP by 2025 and others hold their budgets constant.

We expect that several European countries will push ahead with plans to invest the additional funds that are needed, despite an immediate economic outlook that is challenging because of factors including high inflation and the energy crisis.

3. Stockpiles need to be replenished

The rapid increase in defense spending that we expect to see will transform the context in which the industry operates. Western defense firms have more certainty now than they’ve had since 2001, and perhaps as far back as 1981, when Ronald Reagan oversaw a dramatic defense build-up in the US.

This is likely to be the case for some time. However, the increase in spending also comes at a time when public discourse in the US and Europe recognizes the need for a fundamentally different approach to military equipment.

A particular challenge is the fragmented nature of purchasing processes used by NATO’s European members, which has always resulted in the procurement of a wide variety of different specifications and systems.

The impact of this is clear in Ukraine. While there is a broad NATO consensus on security priorities, the US has tended to provide the best and newest equipment (such as Javelin missiles and Abrams tanks) while European NATO countries have tended to send existing military equipment, often providing the oldest equipment first (such as Soviet era tanks and artillery). One result is that the volume of any one kind of equipment can be small and scattered. European weapons transfers are essential, but they have in some ways made Ukraine’s logistics and maintenance issues more complex.

Europe now has the opportunity to replenish its military stockpiles more effectively. A new model like the European Defence Agency (EDA) Defence Joint Procurement Task Force could use a multi-country purchasing approach to procure materiel at scale and in line with specifications that are relevant and consistent across the continent.

4. Future military capabilities need investment now

It’s important for industry leaders to move decisively now in certain key areas, so they can develop the right capabilities and technologies. The US and NATO have defined several that it believes will be critical in a large-scale conflict against a peer adversary. Defense leaders have also defined several must-win technologies that will enable the fighting force of the future.

Critical investment areas include, but are not limited to:

• Space
• Command, control, communications, computers, cyber and intelligence, surveillance and reconnaissance (C5ISR)
• Precision strike
• Electronic warfare
• Naval forces
• Cyber
• Autonomous
• Artificial intelligence/machine learning
• Materials
• Microelectronics

As budgets are not unlimited, the allocation of funds must be carefully managed to strike a balance between investing in new technologies and maintaining existing capabilities. The need to invest in new capability and technology priorities might normally imply there will be fewer resources available for legacy areas, such as infantry systems and armored vehicles. However, the war in Ukraine has shown these traditional capabilities can still be critically important. For example, they can provide direct support of land-based operations in eastern European. The ongoing experience of fighting in Ukraine will continue to identify new ways of using existing systems.

Nonetheless, it will take a sustained and substantial investment in the productive output of the defense industrial base to deliver the future capabilities that are required. Much effort has already gone into policies that will support dominant players, incentivize new entrants, and improve the ability of the industry to deliver for the future. But more will be needed, particularly in Europe.

Defense companies need to further evolve their strategies. After 9/11, they launched new businesses around expeditionary services, drones and counter-IEDs. Later, as defense demands changed, there was an argument for improving business performance by separating products from services. In the latest wave of change, venture-backed firms are making new inroads and service businesses are exploring the use of advanced analytics.

In Europe we’ve already seen examples of these distinctive moves by industrial players:

• Service-oriented businesses building and acquiring machine learning technology
• Large non-defense industrial firms expanding their presence in defense
• Companies vertically integrating to cut costs
• Established defense product businesses seeking acquisitions in new segments

We expect to see more moves along these lines from defense players as governments clarify their long-range plans and expectations.

Five ways the defense industry should respond

A complicated security environment shaped by these fundamentals holds both short and long-term significance for the defense industry. With the backdrop of a complicated and fast-changing market, we see five priority action steps for European business leaders.

1. Create bold strategies

Up to US$800b of new spending and radically increased demand will transform the defense industry. Investors will expect to see companies make the most of this opportunity and accelerate growth. For mid-market firms, strategies to “double in five years” are likely to be achieved more than ever.

Investments and M&A deals that were not attractive in a relatively flat market should be revisited. There are likely fast-growth streams that do not appear on leadership’s current growth roadmap.

Executives should think again about the breadth of their portfolios, especially where a tighter regulatory environment made vertical integration impossible. They should consider a radical redesign of the way programs are executed, so the business wins more proposals. Finally, they can think about how to create more value from environmental, social and governance (ESG) programs or other enablers in tax and contracting.

2. Improve program performance

Executives need to stabilize the performance of their current franchise programs to minimize the chances of them being cancelled, look to improve the stability of supply chains while making materials more affordable, and make supply more efficient and predictable across their operations. Use digital and connected assets to open possibilities as diverse as ML-based forecasting and digital twin “what-if” analysis.

Challenger companies should try to show they can make fundamental improvements in digital engineering, manufacturing, and service delivery. This will highlight their ability to deliver new capabilities at a lower cost than an underperforming incumbent. The entire market will need to meet investor expectations: steady performance improvement will remain a vital attribute of a high-performing defense businesses.