Steve Dobos, the owner of Texas-based fabricated and machined metal products company Butler Weldments, has been receiving a lot of calls recently.
On the other end of the line are private-equity firms, which are increasingly seeing the submarine industrial base as an attractive investment due to its stability and high barrier of entry.
“It's certainly a high-growth potential for a private-equity firm,” Dobos said in an interview with Inside Defense. “Speaking from my company itself, I get interest all the time. I don't often entertain it, but there's definitely been an upward tick of interest once they know you're in the defense and submarine sectors.”
While the submarine industrial base has shrunk since the Navy stopped building the Ohio-class submarine in the 1990s, strategic competition with China and the construction of the Columbia-class submarine has led to the Navy investing more into the submarine industrial base.
Bryan Clark, a senior fellow at the Hudson Institute who focuses on Navy issues, told Inside Defense he, too, has been taking calls from private-equity firms inquiring about the submarine industrial base.
“You've got private money on the outside saying, hey, submarines seemed like a great way to get into the defense industry,” Clark said. “It's something that's growing and has an almost guaranteed stream of income going for at least for the next couple of decades.”
Navy leadership has consistently identified procuring the Columbia-class submarine as the department’s top acquisition priority, and recent shipbuilding plans have suggested the Navy is considering going from two to three Virginia-class submarines a year.
Novaria Group’s December 2021 purchase of Connecticut-based GK Mechanical Systems, a manufacturer of automatic, positive locking systems and components, is a recent example of this increased interest.
Novaria was acquired in 2020 by KKR, a New York-based, private-equity company.
Bryan Perkins, Novaria’s CEO, told Inside Defense that the company sees the submarine industrial base as an attractive sector.
“It was apparent to us that it was a fairly underinvested sector, in which there would need to be some substantial investment going forward, just given the Asia-Pacific theater of war and the global conflict shift that we're seeing,” he said.
Submarine industrial base history
The lengthy break between the construction of the Ohio-class ballistic missile submarines and the recent start of Columbia-class ballistic missile submarine construction led to contraction in the submarine supply base, according to Clark.
Ohio-class submarines entered the fleet from 1984 to 1997, and the Navy awarded the contract for the first Columbia-class submarine to General Dynamics Electric Boat in 2020.
“There’s been some consolidation, and then a lot of people have just dropped out of the business entirely,” Clark said. “So, what you have now is a large fraction of the suppliers for the submarine industrial base are single-source.”
The country went from 17,000 suppliers to 5,000 suppliers as submarine procurement dropped, Matt Sermon, who leads the Navy’s Columbia program office, said in January at the Surface Navy Association’s annual symposium.
The U.S. does not have the same industrial base to tap into that it had during previous periods of strategic competition, Sermon said, due to globalization and other factors. The Navy is working to rebuild the supply base and its workforce, he said.
Dobos, the Submarine Industrial Base Council’s co-chair, said while the overall number of suppliers has been stable at around 5,000 by the organization’s count, the narrative of a shrinking supply base is more related to capacity than the number of suppliers.
The Navy’s high standards for suppliers adds pressure to the industrial base, Craig Hooper, a naval analyst and CEO of Themistocles Advisory Group, told Inside Defense in an interview.
“To get those products and build them at the specification the Navy desires, you have to do a lot of work,” he said. “You have to get your product certified, and that is often a long, arduous process that companies don’t want to do.”
Hooper said budget uncertainty poses another challenge to suppliers, whose business model often revolves around making a small amount of very specialized parts.
“You're looking at an industry where you don't know what the demand signal is, that's under constant budget pressure,” he said. “The margins aren't so great. It's easy to turn to other things.”
However, the growing focus on countering China has led the Navy to prioritize procuring submarines. Analysts and industry representatives both believe submarine procurement will remain a Navy priority.
The U.S. maintains a large advantage over China in undersea warfare, Clark said.
“The Navy has pretty much determined through its wargaming analysis that the submarines are the ace in the hole when it comes to competing with China or fighting China, if it ever comes to that,” he said.
General Dynamics Electric Boat President Kevin Graney told Inside Defense in a November 2021 interview that the company’s vendor base has grown from 3,000 vendors in 2017 to closer to 5,000 in 2021, he said.
“We want more people to be supplying this product, so we're not beholden to single or sole-source vendors,” he said. “They're going to have their own workforce issues that they're going to have to come through, developing people, developing the efficiency, and really getting the industrial base cooking and humming in the country to support construction.”
The Biden administration expanded the use of the Defense Production Act in December 2021 to aid the Virginia-class submarine industrial base.
Clark said DPA funding will go to submarine suppliers to fund the expansion of their businesses as demand increases. The Defense Department now has the ability to directly fund capital improvements at both the prime submarine shipbuilders and their suppliers.
“Normally the government doesn't have that flexibility,” he said. “You pay a vendor to provide a service or a product to the government. You don't pay them to improve their own infrastructure and their own ability to deliver products later.”
Private equity interest
From a business perspective, the submarine industrial base is a safer bet than the aircraft and surface ship industrial bases, Clark said.
“Every other part of the military industrial base is focused on just staying alive, and just trying to come up with minimum sustaining rates of production and ways to be efficient at that low rate,” he said. “But you've got in the submarine industrial base the opposite problem of trying to grow.”
For a long time, the submarine industrial base has focused on being efficient at delivering a small number of components and is now facing challenges expanding, Clark said. Private equity sees an opportunity to fund that growth, he said.
“You get private money coming in and saying, we'll help cover the infrastructure costs, because we see there being a big return on the back end,” he said.
The low risk and high barrier for entry into the submarine supply base are attractive to investors, Doug Berenson, a managing director of consultancy firm Avascent, said.
“Buying a firm that is already a supplier implies that that firm has mastered the requirements of the U.S. Navy, and its prime contractors,” he said. “Generally speaking, investors everywhere want to make sure that they are guarding against being displaced in the marketplace.”
Berenson said he has noted increased interest by private equity in the defense industrial base as a whole.
“Defense promises a respectable margin, not an enormous margin, but a respectable margin, at relatively low risk with pretty good visibility into the future,” he said.
Dobos said he started hearing more interest from public equity five years ago, with an even sharper increase in interest in the past two years.
The cadence of Navy submarine orders has moved away from peaks and valleys to become more flat and predictable, according to Dobos. This stability has increased private equity’s interest in submarine suppliers and allowed the suppliers themselves to invest in both capital improvements and workforce, he said.
Private-equity investors are usually not in it for the long haul, Dobos said.
“You know private equity’s endgame, it’s no secret,” he said. “It's burn and turn, find any industry that’s in a growth market, turn profit on it, get rid of it. That’s a lot of private-equity strategy.”
Yet private-equity investment can help smaller suppliers through periods of growth, Dobos said.
“If you've reached your capitalization max or something like that, a single owner or family owner can't support the business the way it needs to grow,” he said. “Then maybe there's some definite advantages to it. You just have to have to be in it for the right reason.”
Novaria
Perkins said Novaria has bought 20 businesses in aerospace and defense since its founding in 2011.
“Novaria is that home that can bring capital and specific-related expertise for the end market, to help these businesses that are going through generational transfer really scale up,” he said.
The company got involved in the submarine industrial base in 2015 when it purchased ESNA, a manufacturer of self-locking fasteners. Three of Novaria’s companies are directly part of the submarine industrial base, and others might supply indirectly, Perkins said.
Novaria has a longer-term perspective than other private ownership companies, Perkins said, which separates the company from competitors whose shorter time tables prevent them from investing as much into the companies they acquire.
“What we want are businesses that are perpetual growth engines,” he said. “These are businesses that, if you continue to reinvest dollars versus pulling them out and issuing dividends, they can become really dynamic suppliers in support of a much bigger industrial base.”
Perkins said Novaria projects 5% to 7% growth per year in the submarine supply base sector.
“This is a sector that has the ability to double over a very reasonable period of time,” he said. “Given the scarcity of suppliers who actually understand how to do business, how to make the products to their exact specifications, how to come up with creative solutions, there are preferences to reinvest dollars back into the business.”
Perkins said Novaria acquires companies with the spirit that it will hold onto the companies for a long time.
“Ownership changes do happen,” he said, “But it's not going to drive what we're going to do within the underlying businesses, or how we're going to deal with the customer.”