Chicago Booth Review Podcast Can Anduril Disrupt the US Defense Industry?

Marc Knez: But one, the economics of a large defense contractor is completely dependent on this model in which you get the big contract, you're going to get paid, it's cost plus.

Hal Weitzman: For many decades, the Pentagon has bought most of its equipment from five big defense contractors, Lockheed Martin, RTX, Northrop Grumman, Boeing, and General Dynamics. Is that all about to change? Welcome to the Chicago Booth Review Podcast, where we bring you groundbreaking insights in a clear and straightforward way. I'm Hal Weitzman, and today I'm talking with Chicago Booth's Marc Knez about how Anduril, a tech startup, is threatening to disrupt the defense industry. Could it ultimately lead to cheaper and more effective systems for the military?

Marc Knez, welcome back to the Chicago Booth Review Podcast.

Marc Knez: Great to be back.

Hal Weitzman: Now listen, last time you were here, we talked about your fascination with disruption and innovation, how industries are kind of torn apart and put back together again. And last time we talked about software as a service, this time we were going to talk about defense and how the defense industry in the United States is being completely transformed, maybe at the early days of that.

Marc Knez: Very early days.

Hal Weitzman: Yeah. And it starts with a company, a challenger called Anduril. Tell us about Anduril. What's the point behind Anduril and what are they trying to achieve?

Marc Knez: Sure. So let me sort of just give a brief quick little history and then talk about Anduril. So Anduril is a startup that emerged a number of years ago to provide an innovative approach to border surveillance in a context where the deal-

Hal Weitzman: You're talking about surveillance on the southern border, the US-Mexican border.

Marc Knez: Surveillance on the southern border, right? So you've got all these different. Do we build a wall? Do we just have surveillance? So you've got humans in the loop that are using technology that's helping them identify what's happening at the border, then they respond, that sort of thing, versus building a wall. So this debate challenge has been going on for years. It's not just a more recent time. So for the longest time, the DOD, et cetera, have been looking for solutions for border surveillance because the alternative to technology is you actually have border agents on the border with binoculars trying to see what's going on. And that's historically what we've done.

Given the significant surveillance capabilities that exist within the DOD in more of a battlefield kind of context, the idea was to bring some of those capabilities and apply them to the border. So they attempted that with a large defense contract that Boeing won, and they ultimately developed a solution that was based on classic, somewhat outdated from a commercial perspective approaches to how you would do border surveillance. And what that meant was they created a solution that didn't really leverage modern technology the way they should have. It was a bespoke system that required lots of expensive technology. And ultimately at the end of the day, there was extreme cost overruns. And to make matters worse, it didn't work very well.

Hal Weitzman: Sounds like classic defense contract.

Marc Knez: Yeah, in the extreme.

Hal Weitzman: Outdated, doesn't work, and cost overruns.

Marc Knez: If somebody spends quite a bit of time in the industry, I'm not going to bash the industry too much.

Hal Weitzman: As a taxpayer, that's my perspective.

Marc Knez: Okay. Well, fair enough. But you're alive, you're safe.

Hal Weitzman: That's true.

Marc Knez: Take that in mind. So this was a huge pain point, if you like, in sort of search for a solution. The way the defense contracting tends to work, it's not set up for let's have somebody come in here and provide a really low cost solution that is based on minimal technology that is good enough. So you think that was kind of the setting for a while. The way the contracting works within the DOD, et cetera, is it doesn't lend itself to that. So what happened was Palmer Luckey and a few of his fellow founders, Palmer Luckey invented Oculus, et cetera, and growing up had an interest in the defense industry, et cetera. He's quite a character. He and his team saw an opportunity and had been working on this and given his experience with the Oculus, et cetera, saw an opportunity here.

So what they generated was a very low cost solution, which was a platform, software platform called Lattice. And what Lattice does is it takes in sensor data and image data from low-cost towers because even what Boeing was doing, but Boeing was putting up these big expensive towers around the border that then would gather image data, et cetera. And then that data would go to a central control office and that humans in that office would see images and they would have to integrate this data to try to figure out what was going on and then take action called command and control. That's where the story's going is command and control C2. What Anduril did was they created the Lattice platform, which is a mixture of combination of being able to pull this data in real time off these low-cost platforms that they can just move around.

It's really inexpensive to place one of these towers somewhere. So the towers collect the data. The data wirelessly, of course, goes into the cloud, goes into their platform. It gets ingested as we say. And with the use of AI, it gets processed. So it knows whether or not, is that a cow or is that a human being? And it does it like that. We don't have a human looking at an image trying to figure out, is that a cow or is that a human being? The AI does it. It does it very quickly. And not only is it providing that kind of information in real time, it's also providing recommendations on what actions should be taken. A human ultimately decides, but it's saying, "This is what's happening here. You probably need to deploy these patrol agents over here. It looks like it's heading west in this direction, so you need to get to this point." It's giving sort of suggestions, recommendations on what to do in real time.

So it's command and control, which command and control is taking data in real time, disparate data of all different kinds of forms, processing that data into information, valuable information to support decision-making. So that's command and control. Super important in the defense industry. It exists across the board. So the Lattice platform is providing the basis for that. So they come in with this low cost solution for doing this, and it's a subscription model. Back to our favorite thing. It's a subscription model. They develop it. They didn't get the contract to develop it. They developed it because usually with the DOD, you get a contract, then you go develop it. You might have a prototype that proves it out, but at the end of the day, the cost you incurred, when you actually develop the solution, you know you're going to get paid. As a commercial player coming in, Anduril's coming in and developing the solution and then saying, "Okay, we can put all these towers down, use Lattice, and you start paying a subscription." That's antithetical to what happens in the DOD.

DOD sort of flips that model on its head, which is we have a big massive contract. You prove that you can deliver on it, and then we start paying on it. And then you know as you start going into production, you're going to get paid and then it's cost plus.

Hal Weitzman: So if this commercial player was, as you say, that came from with a background in tech and other types of tech came in and was able to do this, why wasn't Boeing or other defense contractors, massive companies that have access to all sorts of technology and could have bought this kind of solution? Why didn't they come up with it?

Marc Knez: I've spent the last 20 years working with a large defense contractor through a relationship with the school. So an executive education program. And I help them with strategy, teach them strategy, and they do strategy. They work on strategies for their company when I'm with them here in Chicago. And I have experienced over these many years working with really smart people that they recognize that there's alternative ways to do these things. But one, the economics of a large defense contractor is completely dependent on this model in which you get the big contract, you're going to get paid. It's cost plus. And there's massive risk associated with these things and they don't want to take on the risk. So the government is taking on a big portion of the risk in terms of we're going to go build this factory to build this product or whatever the payload is or whatever it is that we are producing.

It might be some complex sensor, many different types of things. It may be artillery, but the point is there's a contract, we're going to get paid, and it's just about cost and cost plus. And the whole economics of a prime defense country's business is dependent upon that. To move to something that's low cost subscription model just doesn't fall within the economics of their business. And so even though there's people perhaps within the DOD, within the primes that understand there are alternative, perhaps better ways of doing this, the contracting vehicles essentially haven't existed to support that kind of work. Now, they've started to emerge over time. The reason why Anduril is quote, and Palantir's in there too, but that's a whole nother story, that they basically showed up and say, "This works. You have a problem. You can ignore us if you want, but if you want willing to pay the subscription, which is a lot less than you were ever going to pay, then we'll give you the solution." So it's kind of like, "Here it is, here's the solution."

Well, the defense contractors don't work that way. They don't show up with the solution and say, "Do you want it?" In the commercial world, that's what you have to do, but that's not the way the DOD operates. And so it's not that the people weren't smart enough, although the people at Anduril are really smart, don't get me wrong, but it's that it's just not their business model. And their business model isn't a business model they select. It's a business model that's been forced upon them over the years by the DOD. So the DOD and the policies that have been set in place for the last 20, 30, 40 years have created this sort of challenge.

Hal Weitzman: If you're enjoying this podcast, there's another University of Chicago podcast network show that you should check out. It's called Not Another Politics Podcast. Not Another Politics Podcast provides a fresh perspective on the biggest political stories, not through opinions and anecdotes, but through rigorous scholarship, massive datasets, and a deep knowledge of theory. If you want to understand the political science behind the political headlines, then listen to Not Another Politics Podcast, part of the University of Chicago Podcast Network.

Marc, in the first half, we talked about what's happening in the defense industry, and you introduced to us Anduril and how they're turning a lot of things on their head, introducing a subscription model, low cost, on time, developing the product before the Pentagon asks for bids and everything else, and then presenting it and saying, "We can give this to you," and how it is a big challenge. You talked about surveillance, border surveillance. What other areas of the defense industry could this affect?

Marc Knez: Well, it turns out-

Hal Weitzman: Are we going to have some weapons on subscription?

Marc Knez: Not weapons on subscription. No, I don't think that you won't have that. But the second part of the story gets to that question, which is border surveillance is a very small market. So the big market is all command and control needs across the DOD. So it's the-

Hal Weitzman: Which just reminds, so that means anywhere there's a lot of data coming in, you have to make quick decisions.

Marc Knez: Yes. Right. And in some sense-

Hal Weitzman: Which sounds like everywhere if you're in the military.

Marc Knez: Yeah, that's right. So in some sense, border surveillance is kind of a relatively benign context for C2. I'm going to use the term C2, command and control, just in terms of the level of risk, et cetera. And in the context of the battlefield, which could be in the air, on the sea, and of course on the ground and all three at once in the extreme, C2 is fundamental, command and control. So you have lots of information coming in from very disparate sources. Much of the information is coming, we call it on the edge, off of actual physical platforms, physical. It could be a submarine, it could be drones up in the air, it could be all kinds of things. And that information's coming in, and then that information needs to be assembled and put to work for decision-making purposes. So that's the way C2 works.

And the solution to that, to the C2 problem, which is how archaic C2 has been within the DOD, and why has it been archaic? Because when the DOD procures a platform where a platform is any sort of, could be a new type of tank, it could be some kind of underwater submarine, anything physical.

I'm going to call it a platform because that's what they call in the DOD. But when I say platform in this context, it's something you can stand on. It's physical. That is a bespoke system that a prime contractor designs and gets built. It has its own internal, if you like, say, call it an operating system. So the software is integrated into that hardware. It's not part of some more open system. So it has its own defined interfaces that are optimized, they think, for that piece of hardware. So when the sensor data is coming off all of these platforms, it's not coming together in a way that easily meshes, can be ingested and then put to work. And in fact, many times it's not possible to do it. You'll see these pictures of individuals that are in the military looking at screens, oftentimes green screens, and they're looking at these screens and there's a screen over here, same information coming in, screen over here.

And there's a human taking that information, putting in their brain, and then doing something with it. It's the sort of thing that I couldn't even believe when I heard this was going on some 10 years ago because C2 solutions have been something I've been seeing teams develop. It's like, this is crazy. Lattice solves that problem. So what Lattice does is it's providing not only is it bringing that information into a common platform where it's formatted in a common way, but then it's instantaneously putting that data to work with AI. And this is all about mostly autonomous systems. So the C2 capability that they built with Lattice for border surveillance has just got expanded and can be now used in many, many different other contexts where now we have in an actual battlefield or battlefield context, we have all this information coming in and we have a C2 platform called Lattice, which integrates much more quickly and is much smarter. It provides much better C2. That's part one of the story.

And again, big question. Well, why didn't somebody in the DOD get this developed? That's a whole nother storyline. Part two is Anduril has this thing, but they can't sell it to the DOD. Why? Because the DOD doesn't know how to buy software. If I can't stand on it, if there's not a cost associated with it, I don't know why am I paying for this thing? Because every new use case for Lattice costs suchly zero. It's software. So Anduril found itself in this situation where they kind of had to replicate what they did with the border surveillance, where they had to go out and buy their own towers, the hardware, and integrate it in with Lattice and provide a complete solution. Because now the DOD can look at that and put a price tag on that.

So that's led Anduril down the path of the... And this gets to what's going to be the optimal business model in the future. It's led them to have to backward integrate into the hardware. So they're making their own UAVs and they're looking to innovate the way they make the UAVs. They're trying to be kind of the sort of Elon Musk of defense manufacturing and running into problems. But the point is they're then finding themselves having to deliver complete UAV solutions. But if you have 10 different use cases, a UAV that's a submarine, a UAV that's flying around in the sky doing surveillance, they both integrate into Lattice and the integration, because we build both of these and they've got about 10 different things they're building. We build both of these, we optimize it to work well with Lattice. Then the complete solution is even better according to them.

But now we go from being really a software company that went out and bought off-the-shelf components, these towers, to now we're having to build very complex hardware platforms. And that's kind of where Anduril is at right now. So the bigger question is, to what extent is this going to disrupt? The defense primes are not going anywhere. It's hard to even conceive of all the things that our prime contractors, large defense prime prime.

Hal Weitzman: But these large defense companies have been in place... There's really big giants that have been in place for decades.

Marc Knez: For decades.

Hal Weitzman: So this is the first time that we've really had a glimpse that that system might be disrupted.

Marc Knez: The disruption is the following. There's one other storyline about this company, General Atomics. It's somewhat of a disruptor in the UAV space. But the reason why we want to distinguish between an industry being disrupted in terms of the way it operates, the economics of the way they operate, et cetera, and then whether or not the incumbents in that industry will get disrupted as this industry disruption occurs. So what's the disruptive forces now are the DODs, they are now have bought into, we don't know if Anduril's going to be the solution, but we know the Anduril platform, what Anduril's developing, that is the solution for the future. We need lots of modularity in the products that we produce. This idea that we buy these big integrated systems that can't talk to one another. And when you want to update them, you have to come up with a whole new program, which is super expensive.

Anduril's coming and say, "No, this needs to be modular. So if you want to update it, it's much easier to improve these physical hardware platforms through modularity and we can produce them more cheaply." They haven't proven this yet, but that's the theory. And so what's going to get disrupted over time is the DOD insisting on our hardware can connect with one another very easily through these software platforms. And we want much more agility on the production side of the hardware because this is too expensive and too slow. And under the current administration, which has been a big benefit to Anduril. Anduril's kind of the poster child for we want to see more of what Anduril's doing.

And the defense contractors are right now where we're at in this interesting time, which is defense contractors say, "Oh, yeah, they've done all the other stuff, but wait until they have to produce something at scale." And that's where we're at this sort of a little inflection point for Anduril. I think they'll probably get there, but at the same time-

Hal Weitzman: There's been some press, isn't there, some media that's been skeptical about their ability to do that. But I wanted to ask you just to finish up, I mean, does all this mean we're going to have. We were joking at the beginning about defense contracts always run too long, too expensive, and then they don't work. Are we going to actually have cheaper defense solutions?

Marc Knez: It's a bigger ray of solutions. So I think that there's going to be a large portion of what the DOD procures, which will include lots of hardware. Software defined is going to be the new thing. Software defined systems, systems that connect with one another, more commoditized hardware. We don't need these exquisite systems. And so that's going to be the push. There's going to be a lot more of it. The defense budget's going to go up no matter who's going to be. It's going to go up given what's going on in the world. And efficiency will be higher. And the challenge is the infrastructure of the DOD and the primes is defined a particular way. They're trying to adjust.

Wartime needs are changing, asymmetric warfare, et cetera. What we've learned from what's going on in Ukraine, what Ukraine has done and what we're experiencing in Iran, that is shifting priorities. The ability of the DOD and the primes to keep up with that is going to be tested and I think they ultimately will. I have a lot of affection for the people that I struggle with this in the prime conduct. They're very mission-driven, but it's a matter of a lot of old routines, contracting practices, et cetera, are going to have to get relaxed in order for this to happen. But it takes back to what I said in the part one, economics always wins no matter how long it's take. It's taking a long time in the DOD.

And that's why I go back to my earlier orientation. That's why one of the reasons I study this is because if it can happen and the DOD can happen anywhere, so I think it will happen.

Hal Weitzman: Okay. All right. Well, Marc, thank you so much for coming back on the Chicago Booth Review Podcast. Talk about disruption in the defense industry.

Marc Knez: Thank you.

Hal Weitzman: That's it for this episode of the Chicago Booth Review Podcast, part of the University of Chicago Podcast Network. For more research, analysis and insights, visit our website at chicagobooth.edu/review. When you're there, sign up for our weekly newsletter so you never miss the latest in business-focused academic research. This episode was produced by Josh Stunkel. If you enjoyed it, please subscribe and please do leave us a five-star review. Until next time, I'm Hal Weitzman. Thanks for listening.