t Air Force Plant #6 in Lockheed Martin's sprawling complex in Marietta, Ga., workers in overalls quietly assemble the first models of the Air Force's next-generation fighter aircraft-the F-22 Raptor. Amid scaffolding, the next Raptors are taking shape at separate workstations, their skeletons a mixture of composites and exotic metals such as titanium, crisscrossed by thick sinews of electric cable. In the Coatings Building next door, a computerized robotic arm evenly applies the coats of radar-absorbing paint so integral to the F-22's "stealth" features. Raptor 4004, the first test F-22 to include the aircraft's full avionics suite, rotates on a turntable inside the nearby Radar Cross Section Building, blasted from all angles by radar pulses in nanosecond bursts. The slightest imperfection from the assembly line can rend a Raptor's cloak of stealth, making the aircraft visible to enemy radar.
Despite assembling the Air Force's most prestigious and highest-priority aircraft, workers at Lockheed Martin know all is not well. Before the Pentagon approves initial production of the F-22 next December, three more demonstration aircraft must be built (for a total of six). Raptor 4004 must fly with an advanced version of the plane's complex radar and avionics system, a key ingredient in proving that the plane can perform as advertised. Indeed, before a $2.5 billion deal for 10 production aircraft can be signed, Congress has demanded that the F-22 successfully satisfy nine separate criteria. If it cannot, key lawmakers have threatened to dramatically delay or cut program funding. Meanwhile, the Air Force has assigned a task force to study whether F-22 production could be done more efficiently at another factory, a move that would essentially doom this venerable facility and many local jobs.
More to the point is the quiet that envelopes the cavernous Plant #6. As part of the vaunted "arsenal of democracy," this facility stamped out 668 B-29 Super Fortress bombers during World War II. Today, aircraft trickle off the plant's assembly lines at an agonizingly slow pace, a metaphor for the low production rates and program uncertainty that currently plague not only Lockheed Martin but the entire defense industry.
Consider how the stock of major defense companies has fared in the eyes of Wall Street during the past 24 months. Last year, the Standard and Poor's Aerospace Index fell about 8 percent, while the broader S&P 500 index rose 21 percent. Shares of Lockheed Martin Corp., the largest defense contractor, plummeted a precipitous 48 percent in 1999. Shares of Raytheon fell 50 percent, General Dynamics' shares dropped 10 percent, and Northrop Grumman fell 30 percent. The only exception among the top defense firms was a 24 percent increase at Boeing Co., which also happens to be the largest commercial aerospace firm in the country. Although a number of aerospace and defense contractors posted better-than-expected financial results for the last quarter, which ended in July, a report by a Defense Science Board panel on the state of the defense industry noted that the 1999 combined market valuation of the 10 top defense companies was about equal to that of Procter & Gamble by itself. The once heralded and feared "military industrial complex" now accounts for less than one-fourth of the value of Microsoft Corp.
The Defense Science Board panel, which interviewed top executives of many defense companies as well as Wall Street analysts and investors during a three-month review, was unequivocal in its conclusions about the financial health of the defense industry. "Aggressive, near-term actions are required to reduce the risk that the Defense Department's industrial base will be technologically weakened, less competitive and unresponsive to our defense needs," the panel's draft report concluded. "Lack of action would further undermine investment community support and workforce morale. Fixing these problems is critical to our future national security."
In comments at the Global Air and Space symposium in May, Philip Odeen, the head of Washington operations for TRW and the chairman of the Defense Science Board panel, said defense firms' problems were the result of a combination of factors, including program uncertainty and a lack of steady and adequate funding; a lack of understanding of industry needs and requirements on the part of uniformed and Defense Department personnel; and Wall Street's infatuation with the stocks of cutting edge "dot.com" companies to the detriment of more traditional industries. A number of experts also believe that defense companies must shoulder much of the blame for mismanagement of a number of major mergers and consolidations, as well as well-publicized problems with key programs. Wherever the blame rests, however, almost no one denies that the slide in defense industry stocks may herald fundamental problems for the United States' defense industrial base and potentially for U.S. national security.
"The sharp decline in stock prices has had a big impact on the defense industry, because defense workers have seen the value of their stock options and 401K plans go down, and that has a psychological impact," says Odeen. At the same time, he says, there is a direct overlap in the kinds of skill sets that are critical to large defense programs and the new Internet and high-tech economy. "We're competing with the dot.com companies for people with critical skills, and that's not easy with some of the stock options and excitement those new companies are generating," Odeen notes. "I talked to one manager of a major defense program who lost 100 people in a short period, about 75 of whom went to a dot.com company. That, in turn, has exacerbated a problem the defense industry has with a graying workforce. A third of the defense workforce is over 50 years of age. So we're about to lose a large number of talented people over the next few years at a time when we're facing very tough problems attracting new talent."
A number of defense analysts believe the Pentagon will have to move more aggressively to bolster the bottom lines of key defense contractors if it wants to maintain an adequate industrial base. In July, for example, the Pentagon issued new policy guidance ordering the military services to ensure that no new weapons programs worth more than $50 million unduly favor a single contractor. The initiative was one of several that Defense Secretary William Cohen has taken in an attempt to restore financial health to the shrinking defense industry. "I am asking that Defense Department components consider the effects of their acquisition and budget plans on future competition," said Pentagon acquisition chief Jacques Gansler, announcing the policy change.
After Lockheed officials warned that the company didn't have enough foreign orders for its new and upgraded C-130J transport planes to warrant keeping the production line going at Marietta, Ga., the Air Force recently agreed to spend $400 million buying C130-Js. Because that buy comes much earlier than the service had projected a need for additional aircraft, a number of experts interpreted the move as another attempt to keep a key contractor on life support.
"I think there is good reason to worry about the continued capacity of our industrial base to support asymmetrical advantages that we enjoy in warfare," said Air Force Chief of Staff Gen. Michael Ryan in an interview. "We are very good because we have a great industrial base that puts forth equipment that is top-rate and better than anyone else's equipment. For a uniformed officer who is responsible for a bunch of wonderful people working for him, my feeling is they deserve the best equipment in the world. So I am worried about being able to maintain the best and most cost-effective armament in the world. The entire industrial base has shrunk to a worrisome level."
Consolidation Gone Awry
It wasn't supposed to be this way. When former Defense Secretary William Perry gathered the captains of defense industry together for a 1993 dinner that came to be known in industry circles as "The Last Supper," his message was blunt. With the Cold War relegated to the history books, Perry said, more than half of the companies represented would not survive the downsizing to come. In each category, whether it was aircraft and space systems or tanks and ground systems, he told the industry leaders that the Pentagon would be able to support perhaps two suppliers where five or six existed. Like dinosaurs at the dawn of the Ice Age, the defense companies could adapt or face extinction. Companies that did successfully adapt, however, would become lean, mean industrial machines capable of thriving in the new post-Cold War economy.
Perry's dire prediction was driven by a combination of rapidly declining defense budgets and DoD's evolving Robin Hood strategy of robbing from rich modernization programs to give to poorly financed military readiness accounts. That strategy-essentially trading long-term procurement pain for short-term gains in readiness-put incredible pressure on the structural integrity of a rapidly contracting industrial base. The fact that only in recent years have long-anticipated and relatively modest increases in procurement spending appeared greatly exacerbated the strains. During the long lull in modernization, the factory of democracy-once called the "fifth service" and ranked in importance right alongside the armed services themselves-was all but silenced. The Pentagon essentially put defense industry on life support, closely monitoring its vital signs and applying emergency measures where necessary, but otherwise letting a Darwinian marketplace judge who would survive.
Left with little choice, defense firms responded with a frantic series of mergers, acquisitions and divestitures. From more than a dozen major players, the number of big contractors shrank to less than a handful. Rather than prospering, however, the surviving behemoths have found themselves constantly elbowing each other in an increasingly brutal game of musical chairs, all vying for one of the last few major procurement programs left in the defense budget. In many cases, the losers left standing when the music stops will be out of the game.
That was the message behind the Pentagon's recent flirtation with the idea of splitting the Joint Strike Fighter program between Boeing and Lockheed Martin, rather than awarding a "winner take all" contract next year as originally planned. The JSF program, believed to be worth up to $300 billion after production begins in 2008, is the last contract for a major manned fighter to be awarded until at least 2040. Pentagon officials clearly worried that awarding the contract to a single company would mean the loser would go out of the fighter business, leaving the United States with just one fighter manufacturer (mergers have eliminated McDonnell Douglas, Grumman and Vought).
"The only thing we're thinking about is whether there would be some advantage to trying to keep the loser, if you will, involved in the program in one way or another so that when we went into production we could then compete the two," said Gansler, who assembled a seven-person panel to study alternative buying strategies for the plane. One would have the Pentagon choose a winning design, but then award production contracts based on a split between the two competitors that would reward the winner but keep the other player in the game.
Concerned by published reports indicating that splitting the JSF award could add 10 percent to the cost of the program, a number of key lawmakers questioned whether the Pentagon's reappraisal would be fiscally prudent. "I too have become increasingly concerned about the lack of available competition, as well as the companies that are able to still serve this arena," Rep. Jerry Lewis, R-Calif., chairman of the House Appropriations defense panel, said in an interview with Defense Week. "The marketplace does need some massaging. I understand why the administration has been looking at possibly rethinking the way they look at the [JSF] contract. But if they are going to make some changes, or restructure this contract, I want to know about it. What's that going to do to our costs per aircraft?"
Recently, the Pentagon announced that it did not intend to change its plan to award the JSF contract to one contractor rather than divide it between the main contestants. In a similar case, however, Gansler gave a green light earlier this year for the contractors competing for the Air Force's Advanced Extra High Frequency satellite program to join forces as a national team. That teaming arrangement is similar to the Lockheed Martin/TRW/Hughes team now in place for the MILSTAR II satellite development. Both episodes illustrate just how uncomfortable the Pentagon has become with a defense industry consolidation that has continued longer, been more radical, and left more companies in the dust than many experts had originally anticipated.
When the Justice Department and Pentagon stepped in and scuttled Lockheed Martin's attempt to merge with Northrop Grumman in 1998, many experts took it as a signal that the era of merger mania had run its course. Already the major players were themselves merged entities, reflecting Lockheed's combination with Martin Marietta, Northrop's merger with Grumman and Boeing's acquisition of McDonnell Douglas. When Lockheed started eyeing a marriage with Northrop Grumman, however, the Pentagon finally asked the question on the minds of many defense experts: Where will this consolidation finally end?
Part of the problem is that while the merger process has saved taxpayers an estimated $3.5 billion by introducing more efficiency and reducing excess capacity, the challenges of merging disparate cultures has led to a number of management snafus and troubled programs. The resultant disappointing earnings statements and the uncertainty and peculiarity of the defense market began to sour Wall Street on the defense industry's earning potential.
Lockheed Martin, for example, has been rocked in recent years by the explosion of two Titan rockets, the malfunction of the Mars spacecraft, cost overruns on the C-130 transport, and test failures of the Theater High-Altitude Area Defense missile system. The company's earnings in 1999 fell by half from earlier projections, and the company undertook several shakeups in its senior management ranks. Meanwhile, radar and missile maker Raytheon (which had acquired Hughes Aircraft, E-Systems and Texas Instruments' defense division) revealed a sobering $668 million pretax charge against earnings last year, owing to systemic problems in its business groups. On just one contract-to refurbish the Navy's P-3 Orion surveillance aircraft used primarily to hunt submarines-Raytheon's Aircraft Integrated Systems unit reportedly lost as much as $70 million last year because it found the job much more difficult than anticipated. Since September 1998, Raytheon has issued three profit warnings.
Bill Swanson, president of Raytheon's electronics sector, still says the mergers were difficult but necessary. "The consolidation of the defense industry we've witnessed over the past decade was a necessary response to a radically changed geopolitical environment. Since the fall of the Berlin Wall, literally hundreds of companies either left the defense business or were swept up in mergers and acquisitions," he said at the Global Air and Space symposium in May. "And while more than 2 million jobs have been eliminated in this industry, we're still burdened by overcapacity."
Raytheon's experience trying to combine its own corporate culture and systems with those of three other companies reveals both the challenges and potential inherent in defense industry mergers. "To reap the benefits of combining four different companies, we had to shed significant excess real estate and personnel," said Swanson. "We reduced our costs base by 10 to 15 percent by consolidating offices, closing facilities and establishing 14 consolidated manufacturing facilities where 68 previously existed. Because we had 37 geographical management sites around the country, each with its own legacy financial system, we had to invest in a common financial planning system that would cut across the entire company. At the same time, we're seeing an estimated $100 million savings in productivity increases, we're concentrating on our core business of radar and sensor technology, and we're continuing to mold Raytheon into the company that we all envisioned at the beginning of these mergers."
Robert Johnson, head of the Aerospace Division of Honeywell, which merged with Allied-Signal last year, said the combination of those two venerable defense companies gave corporate leaders a chance to reassess both their strengths and weaknesses. "While we were waiting for approval of the merger, we talked to the customers of both companies, and they made clear to us what the best and worst practices of each was in the past. Then we focused all of our energies on what our customers said the best practices were," said Johnson at the Global Air and Space symposium. "In terms of best practices, we decided first to get over the terror and fear of merger as quickly as possible so the organization could focus on the future. We communicated frequently with both employees and customers to relieve that anxiety and fear. And within about 45 days of the merger, I think we successfully created a new culture that gave us a fresh start."
Surprisingly strong financial results reported in July by Lockheed Martin, Raytheon and Northrop Grumman have given the industry some hope that the worst may be behind them. Lockheed and Raytheon, for instance, reported improved cash flows and significant growth in their backlogs of new orders during the second quarter, and Northrop Grumman also saw its cash flow and earnings improve despite a revenue decline largely attributable to a falloff in deliveries of the B-2 bomber.
Increased Pentagon spending and positive corporate restructurings may be leading investors to "see the glass as half full instead of half empty," Byron Callan, an analyst at Merrill Lynch & Co., told The Wall Street Journal.
With the Justice Department and Pentagon looking skeptically at any new mega-mergers (most recently, Boeing's proposed $3.75 billion acquisition of Hughes Electronics Corp.'s satellite-making operations has been delayed as a result of scrutiny by the Justice Department and the European Commission), many defense companies have focused on maximizing overseas sales, exploring trans-Atlantic teaming arrangements, and considering smaller acquisitions.
For example, Lockheed Martin signed a $6.4 billion deal with the United Arab Emirates for the purchase of 80 advanced model F-16 fighters. Called "Desert Falcons," the aircraft will be newer and more sophisticated even than the ones flown by the U.S. Air Force. Within the past three years, Defense Secretary William Cohen has made five trips to the Emirates, and President Clinton reportedly intervened at least twice by personally phoning UAE President Sheik Zayed bin Sultan al Nahyan. In a related development, State Department and Pentagon officials are ironing out new export rules that would streamline the approval process for overseas arms sales and allow nonclassified military sales to Britain, Australia and Canada without a license. Those changes are expected to facilitate more trans-Atlantic collaboration between U.S. and European defense firms.
In another move that augurs increased trans-Atlantic defense-industrial links, Northrop Grumman Corp. recently agreed to explore business alliances in major technology areas with DaimlerChrysler Aerospace AG of Germany. Under terms of the agreement, which was signed last spring, Northrop and DaimlerChrysler will study ventures to build ground surveillance systems, wide-bandwidth data links for reconnaissance uses, and unmanned aerial vehicles. Such alliances are seen by U.S. and European officials as a way to cut production costs, reduce continued overcapacity in the defense sectors on both sides of the Atlantic, and improve the equipment interoperability of the NATO allies.
After top Pentagon officials suggested last year that they would even look favorably on trans-Atlantic mergers of defense companies, however, congressional concern caused U.S. officials to back off and focus on encouraging teaming arrangements. Congress is expected to look skeptically, for instance, at the recently announced deal for Lockheed Martin to sell its Aerospace Electronics Systems business to Britain's BAE Systems for $1.67 billion, placing very sensitive electronic warfare technology into the hands of a foreign-owned company.
"I don't really see a major trans-Atlantic merger taking place in the next four or five years," Bernard Retat, a senior corporate executive at Thomson CSF, a French defense contractor, said at the Global Air and Space symposium. International regulations and domestic concerns about the sharing of very sensitive technology present a major obstacle to such mergers, said Retat and others.
The Defense Science Board Panel, however, believes the U.S. government must do more to help a struggling defense industry regain its equilibrium. A fundamental part of the problem, said panel members, is that Pentagon and military officials still do not fully understand what makes the defense industry tick. "One general told me that in 35 years of service, he had received only a single briefing about how the defense industry works," said panel chairman Odeen. "We as an industry need to do a much better job of explaining the importance of issues such as cash flow, capitalization and return on assets."
Specifically, the Defense Science Board panel recommended that DoD increase its level of progress payments-money paid to a contractor each time it completes a major portion of work on a program. The panel also urged the Pentagon to allow companies to earn more profit on successful programs. Currently, defense contractor profits are capped at 10 percent on a contract.
To encourage companies to further downsize and close underused facilities, the panel also recommended that the Pentagon allow them to keep cost savings they achieve through efficiency measures for three years. Under current rules, firms must immediately return such savings to the government.
The Defense Science Board also urged the Pentagon to invest more money in research and development, and structure contracts so that companies can earn profit during the R&D phase of a program. In the past, companies were often willing to lose money in the R&D phase to win lucrative production contracts. With so few production contracts now available, however, that practice can become ruinous. Experts also noted the administration's plans now call for cutting R&D funding by 14 percent over the next five years to fund more procurement. The panel also supported the creation of a venture capital fund to nurture new defense technologies. Finally, the panel urged the Pentagon and Congress to approve more multiyear contracts and funding for defense programs to relieve the uncertainty that has plagued an industry where critical funding and support is susceptible to wild swings in any given year. "Our business needs to get more predictable, because Wall Street doesn't like unpredictability," says Raytheon's Swanson.
John Douglass, president of the Aerospace Industries Association, believes that the problems confronting the aerospace and defense industry are so pervasive that nothing less than a presidential commission is required to assess the future of an industrial sector that accounts for much of the United States' recent prosperity.
"We are the single biggest exporting industry in the American economy. In terms of a positive trade balance, we're almost equal to all other sectors of the U.S. economy combined," said Douglass at the Global Air and Space symposium. "Yet if we want to maintain our status as the world's number one aerospace power, we need to see some major changes. We're a very regulated industry that falls under the authority of a wide spectrum of bureaucratic agencies, many of which don't talk to each other. Nor does the government well understand how we do business and the challenges we face as a result of all of these mergers and consolidations. We need multiyear procurements to stabilize programs, but that will take the will of Congress to enact. So in terms of our vision for this industry, the single most important accomplishment must be to get George Bush or Al Gore to promise to form a Presidential Commission on the Future of the Aerospace Industry. Because the issues that affect our health are so broad they can only be solved by the industry working in a coordinated way with a new administration."
James Kitfield is a staff correspondent at National Journal.