Under ever-growing scrutiny from Wall Street, the defense sector
needs to improve its financial health by speeding up the glacial
pace of reform and investment, executives from government and industry
told a recent conference in Washington, D.C.
“We need to reduce cycle times, slash bureaucracies and restore
the operational and financial strength to our defense industrial
base ... to enable that base to better respond to the needs of the
armed services,” said Darleen Druyun, principal deputy assistant
secretary of the Air Force for acquisition and management. Druyun
made her comments at the Defense Reform 2001 conference and exhibition,
sponsored by the American Association of Aeronautics and Astronautics
(AIAA).
The time to act is now, said Vance Coffman, chief executive officer
of Lockheed Martin Corporation, headquartered in Bethesda, Md. “The
tectonic plates within the defense community are shifting. We know
that there will be decisions made within the next few months that
could well determine not just the health of the defense industry,
but also the ability of the United States armed services ... to
carry out their missions well into the next century,” Coffman
said.
Future decisions on force modernization and weapon systems procurement
by Defense Secretary Donald H. Rumsfeld will have a dramatic effect
on the financial viability of the defense industrial, officials
said at the conference.
Changes to the current defense acquisition processes were not mentioned
as priorities in the Bush budget proposal, but they were discussed
in-depth at the conference as potential solutions to the stagnant
defense market. “The current system of financing and paying
for weapons systems is inefficient and wasteful,” Druyun said.
According to Harry Stonecipher, president and chief operating officer
of Boeing, headquartered in Seattle, Wash., an inefficient procurement
environment has rendered defense a “no-growth” industry.
“The defense industry has a growth rate of 4 percent to 6
percent a year. Essentially, we are trapped in a no-growth industry,
which we prefer, because it indicates peace,” he said. In
order to modernize the military and make the defense industry more
vibrant, Stonecipher recommended the adoption of public-private
partnerships, “halting the turbulence” of the acquisition
process, implementing best-value procurement, and streamlining export
control policies.
Acquisition regulations are to blame for many of the problems in
the procurement culture today, industry officials said. According
to the conference’s final report, “A Blueprint for Action,”
defense modernization is hampered by unnecessarily burdensome regulations,
which “further harm industry’s ability to deliver the
best weapons and equipment to the warfighter.”
Revamping the procurement culture would do a great deal to rebuild
trust between the government and contractors, Coffman and Druyun
agreed. Coffman advocated a “procurement system driven by
an entrepreneurial, goal-oriented process instead of today’s
risk-averse, over-regulated status quo.” There should be “more
of that simple, basic, human quality in the acquisition process
called ‘trust,’” he said. Druyun suggested that
the government move to multi-year procurements. “It is critical
for the government to test this concept by using some transformational
pilot programs from each of the services, to begin to rebuild that
bridge of trust and demonstrate that stable funding yields stable
programs,” she said.
What Wall Street wants from the defense sector is “predictable
earnings performance and returns on capital that are competitive
with other large industrial sectors,” according to the conference
report. However, “given the excess volatility of major defense
programs, the vagaries of the budget process, and the lack of interest
among acquisition officials in the industry’s long-term health
and viability, very little is certain or steady.”
Industry analysts at the conference echoed this sentiment.
Defense Marketplace
According to Loren Thompson, chief operating officer of the Lexington
Institute, headquartered in Arlington, Va., advice from Wall Street
analysts is welcome. “Last year, the procurement budget of
the Defense Department was equivalent to the amount of money spent
in this country on illegal drugs. The concept of a robust, resilient
defense industry has now been changed to a medium size struggling
industry dependant upon the good of the government for its survival,”
he said.
The defense industry has not achieved healthy return-on-investment
levels of capital, said Pierre Chao, managing director and head
of the aerospace and defense group at Credit Suisse First Boston.
“I find it ironic that we fought a cold war for 50 years upholding
the principles of democracy and capitalism, yet the acquisition
process, on a daily basis, violates one of the basic tenets of capitalism,
which is an appropriate return on investment for risks taken.
“If you took the top 30 defense companies in 1990 and compared
them to the top 30 companies today, you’d find that the total
market capitalization is down 15 percent. There’s capital
floating out of this industry. The taxpayer takes the full burden
of paying for this industry when investors could help it along,”
he said.
Chao made several suggestions to reinvigorate the financial health
of the defense industry. He recommended that the capital gains tax
be cut in half for anyone who invests in defense companies. He also
said that defense executives need to do more “bragging”
about their industry.
Because it’s been around so long, the defense industry is
considered old economy, but there is really no higher technology,
Chao stressed. “Every time a space launcher goes up, a plane
takes off or a ship sets sail, that’s a minor technological
miracle,” he said. Defense companies are doing good work,
but it is important for people who work in the industry to “talk
themselves up,” to encourage others to invest, Chao said.
The Pentagon also would benefit from having government analysts
work more closely with Wall Street. “There should be Pentagon
outreach to Wall Street. The Defense Department could use an industrial
relations person,” Chao added. Since Wall Street analysts
usually only hear news and views about the defense industry from
the companies themselves, it is often difficult to determine what
is a sales pitch and what is legitimate information, Chao explained.
The AIAA conference report endorsed this view. “Creating
a vehicle for more regular interaction between analysts and Defense
Department officials who could clarify program plans and actions
would greatly enhance the financial analysts’ ability to project
company performance and program valuations,” the report said.
Stability in the procurement system is important to analysts and
industry members alike, according to Byron Callan, first vice president
of Merrill Lynch, headquartered in New York. Defense companies need
greater program stability and predictability in order to stop capital
markets from raising the cost of borrowing. The industry needs to
improve its flexibility to adjust to changing trends, he said. “Higher
agility will yield a more competitive return,” Callan added.
For the industry to become vibrant once again, the Defense Department
“shouldn’t be a slave to Wall Street,” said Wolfgang
Demisch, managing director of Wasserstein Perella Securities Inc.,
a Wall Street firm. He urged the Defense Department to go back to
its roots in research and development. “The Defense Department
has been an engine of development and it should get back to that,”
he said. The department made major innovations during the Cold War,
Demisch noted. “If the Defense Department concentrates on
new ways of doing things, this will create an opportunity to achieve
sustained superior growth,” he said.
Congress needs to be convinced that more money should be invested
in defense, which could set off a market turnaround, Demisch said.
“You can make a coherent argument that defense is the national
development technology test bed, as well the national insurance
policy,” he said. “Under those circumstances, you want
to encourage technology development from defense, and you want to
encourage your best and brightest to go into that field,”
he said.
Demisch noted that John C. Calhoun—secretary of war under
President James Monroe in the early 1800s—was a pioneer of
mechanization who spent huge amounts of the money to make muskets
with interchangeable parts. “Until he did that, industrial
work was a craft rather than a process. This has paid off big-time,
long-term. There is an accepted role for defense as a force for
technological advancement embedded in our history,” Demisch
added.
The consequences of drastic cuts defense procurement and research
could be dire, and could lead to the industry’s obsolescence,
according to Heidi Wood, vice president at the Wall Street investment
firm of Morgan Stanley Dean Witter. “Unless there is a significant
change in the culture, the market will vote with their feet.
“You can see in the last decade the decreasing relevancy
of the sector in the total Standard & Poor’s 500,”
Wood said. “Unless there is change, unless the market remarkably
turns around, the market will continue to ebb down,” she said.
Wall Street, however, recognizes the strengths of the defense sector.
“Some of the most amazing cutting-edge technologies—that
have created entire commercial sectors—stem from the defense
industry,” Wood said. “I think the defense sector ought
to be getting its fair share of it.”