Analysis-Silicon Valley-backed defense firms face growing pains after hot streak

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By David Jeans, Mike Stone and Joe Brock

SIMI VALLEY, California, Dec 8 (Reuters) – U.S. defense technology companies have roughly doubled their share of Pentagon contracts over the past year, but they face growing pains as they try to evolve from hot startups into heavyweights capable of building weapons at scale.

Valuations for unlisted firms developing everything from unmanned “wingman” fighter jets, drone boats and AI-driven autonomous software have surged this year, alongside a rise in small Pentagon contracts, as the success of drones in Russia’s war on Ukraine has intensified interest in next-generation weapons.

For instance, drone boat manufacturer Saronic Technologies, which is building a shipyard in Louisiana, was valued at $4 billion in February. Anduril Industries, the drone and autonomous weapons startup led by Palmer Luckey, doubled its valuation to $30 billion in June. And in a funding round last month, radars and sensors company Chaos Industries doubled its valuation to $4.5 billion. 

Now, the Silicon Valley-backed companies face a bigger challenge: moving beyond research and prototype contracts to producing weapons at scale and competing with established defense firms, according to interviews and speeches by more than a dozen industry executives at this weekend’s Reagan National Defense Forum in Simi Valley, California.

“The defense tech space is booming, there are many people bringing commercial innovation to the defense area,” said Christopher Calio, CEO of RTX, the defense giant behind the Patriot missile defense system and the engine that powers the F-35 fighter jet.

“I will say this, it’s one thing to design and innovate. It’s another thing to build a prototype, and then it’s an entirely different ball game to then scale manufacturing,” Calio added.

SILICON VALLEY GETS LARGER SLICE OF PENTAGON PIE

Defense startups captured 1.3% of Pentagon contracts to defense firms in the first three quarters of this year, up from 0.6% a year earlier, according to data provided to Reuters by Govini, a Virginia-based defense analytics firm. 

Meanwhile, the big defense “primes”, which include Boeing, Lockheed Martin, RTX and Northrop Grumman, held steady at 92% of Pentagon contracts. European defense firms’ share slipped to 6.6% from 7.4%.

“There will have to be more companies that have a shot at winning some of these larger contracts,” Anduril Chairman Trae Stephens told Reuters. But, he added, “this is a hard, hard business. And the DOD (U.S. Department of Defense) is not going to create 10 new primes. There’s not enough money to go around.”

The annual Reagan forum was a collision of eras, where four-star generals and Washington defense CEOs in tailored suits mixed with baseball-cap-clad AI and drone company founders, debating how to scale new technologies for the battlefield against the backdrop of Simi Valley’s rolling hills.

U.S. Defense Secretary Pete Hegseth said the Pentagon would move away from a “prime” dominated culture to a system where nimbler commercial companies would speed up weapons production to help counter China’s rapidly growing military.

“Our objective is simple, if monumental,” Hegseth said in his keynote speech. “Transform the entire acquisition system to rapidly accelerate the fielding of capabilities and focus on results.”

HARD TO CHANGE PENTAGON CULTURE

Defense executives said delivering on Hegseth’s vision will be tough given entrenched political interests, a backlog of Pentagon mega-projects, a bureaucracy wedded to old ways and powerful defense giants with lobbying muscle.

Most defense tech firms are a long way off transitioning from a prototype contract, which might be worth $10 million to $30 million, into a major program with production targets like those the Pentagon has awarded to big defense firms for decades, said Zach Shore, chief revenue officer at Hermeus, an Atlanta-based company developing an uncrewed hypersonic military jet.

“That next layer of bureaucracy, that’s the next wall that a lot of companies are going to come up on,” Shore told Reuters.

This year, the Pentagon awarded large swathes of major programs – including Ukraine military aid packages, an Air Force fighter jet initiative, and the $175 billion Golden Dome missile project – to legacy defense contractors.

Despite these challenges, JPMorgan Chase CEO Jamie Dimon, who announced $10 billion of direct equity investments in defense, manufacturing and tech companies in October, fired a warning shot at any legacy defense contractors who might be resting on their laurels.

“There’s a valley of death for big companies too, who go by the wayside, usually driven by complacency, arrogance, bureaucracy,” he said on a panel at the summit.

NEWCOMERS AND OLD GUARD FORGE PARTNERSHIPS

Heeding this call, many of the old guard of the defense industry expressed a willingness to embrace partnerships with next-generation defense companies.

“As the defense industrial base surges to support the growth, we need to leverage the established companies and the new entrants,” L3Harris Technologies CEO Chris Kubasik told Reuters.

In September, Shield AI, a San Diego-based software and drone firm, announced a partnership to build autonomous vessels with HII, America’s largest military shipbuilder. Last month, Anduril and South Korea’s HD Hyundai Heavy Industries said they were teaming up to build ships for commercial and military use.

Zach Mears, Anduril’s head of strategy, said the U.S. defense industry was approaching a tipping point after decades in which a small club of contractors dominated Pentagon deals. 

“The light switch is in the middle of being flipped,” he said. 

(Reporting by David Jeans, Mike Stone and Joe Brock; Editing by Jamie Freed)