For decades, we referred to the “defense-industrial complex”
as if contractors were merely captive extensions of the Defense
Department. It is clear, however, that last summer’s Wall
Street abandonment of traditional aerospace and defense stocks and
the current debate over the potential cancellation of several high-visibility
programs call for the creation of a new “national-security
That model must integrate the long-term needs of the nation’s
defense with the shorter-term scrutiny of shareholders on Wall Street.
Two messages should be made clear during the ongoing Quadrennial
Defense Review by the Bush administration. First, the Defense Department
must have a robust long-term defense industrial base to support
the administration’s strategic objectives, such as a national
missile defense, tactical air superiority, precision-strike and
deep-strike capabilities, tactical airlift, command and control,
as well as airborne surveillance and jamming.
Such focus drives the need for “leap-ahead” technologies
in key areas. However, breakthroughs in critical “leap-ahead”
technologies endorsed by the administration are tied directly to
defense-unique subsystems and stand-alone technical capabilities.
Specifically, it is less likely that major breakthroughs in these
“leap-ahead” technologies will occur at the platform
level. Rather, such breakthroughs are much more likely to occur
at the subsystem level, such as electronic countermeasures, fire
control, sensors and integrated communications, among others. This
is a fundamental shift from the traditional philosophy that focused
on platforms, not subsystems.
Second, the defense industrial base must be well capitalized, in
order to drive those breakthroughs in “leap-ahead” technologies.
Given the cost-accounting structure of government contracting, contractors
in defense-unique, research-intensive areas must have constant capital
infusion, via issuance of stock or debt, to develop new areas of
technical expertise or even to capitalize substantial portions of
the front-end of major production programs. There is a direct correlation
between the ability of contractors to get access to capital and
investors’ perceptions of the ability of those contractors
to generate reasonable return-on-investment.
Shorter-term “value investors” will accept strong cash
flow and reasonable profit, even in a mature industry with such
limited top-line growth, so long as there is “controlled-risk.”
Simply put, from an investor’s perspective, the immediate
value of a particular stock is a function of current corporate assets,
plus the projected future “value” of the company. This
is at the heart of almost all stock-valuation models. But while
projected top-line growth will have a proportionate effect on future
“value” projections, risk has a much greater adverse
impact on stock valuations. Consequently, true value investors often
will invest in undervalued companies with strong business fundamentals
and controlled-risk—even with modest growth in projected sales—over
companies with large growth potential, but major risk, as in the
While many government officials support increases in defense spending,
the future of the Pentagon’s budget cannot be predicted. Under
the Bush administration, defense dollars are competing against tax
cuts, and reforms in Medicare, Social Security and education.
Nevertheless, literally billions of dollars can be capitalized
by shareholders in a true controlled-risk environment. This requires
consensus between key government leaders, shareholders, and industry
management on a clear approach to generate a reasonable annual return-on-investment
Government officials, industry management and shareholders should
work hand-in-hand in the following areas:
Following are examples of decisive actions needed to create a more
investor-friendly environment for the defense industry:
1. The Pentagon should selectively reassess acquisition strategies
in on-going “winner-take-all” competitions, such as
the Joint Strike Fighter, to rejuvenate the anemic industrial base.
Almost the entire future fighter market soon will be determined
by a single down-select. This affects competing contractors’
ability to raise capital, because stock models directly compute
current stock price as a function of both future growth and future
risk. Such imbalanced risks warrant careful analysis of alternatives,
such as leader/follower or “competitive split” (winner
takes the most lucrative subsystems). The industry also should validate
the cost/schedule impacts that would result from restructuring those
2. Given the irrevocable Defense Department commitment to “bundled”
platform competitions, subcontractors must complete the long overdue
mid-tier industry consolidation. This is critical, because there
generally are only two prime contractors for most platforms, such
as fighter aircraft, and there is only room for one subsystem subcontractor
on each competing team. After final down-select, only one subsystem
may eventually go into production, if ever.
3. Reshape antitrust evaluations to ensure that future antitrust
evaluations also incorporate the Defense Department’s clear
commitment to an integrated U.S./NATO defense industrial base. There
are a large number of defense-unique, research-intensive subsystem
markets that still require extensive consolidation to generate research
and development “critical mass,” while shedding major
pockets of excess production capacity.
4. Restructure troubled “legacy” programs. When a healthy
contractor acquires a less competitive contractor, it usually inherits
at least one or more troubled “legacy” programs with
major technical, schedule and financial difficulties. It is vital
to immediately identify such troubled “legacy” programs
for restructuring with the customer, to ensure that additional management,
technical and financial resources are allocated to fix schedule
slippages and technical problems. This is at the heart of controlled
risk: ensuring that the government, industry and shareholders all
have a clear understanding of the risk-to-reward relationship in
troubled legacy programs, so that the acquiring contractor can profitably
take aggressive steps to meet the customer’s long-term requirements.
5. Award multi-year contracts, at least one per major contractor
and at least three per service, to attract value investors, since
multi-year contracts substantially increase stock valuations due
to investor perception of controlled risk. The perceived decrease
in risk will likely have a substantial impact on stock valuation.
This will enable contractors to immediately raise necessary production
capital by issuing stock or debt.
6. Move to a two-year appropriations cycle on research, development
and procurement. This would help to stabilize programs, “lock
in” savings to the Defense Department and create an environment
of controlled risk to value investors. U.S. constitutional prohibitions
against standing armies requires that military personnel, operations
and maintenance funding must be appropriated on an annual basis.
But Congress could readily move to a two-year appropriations cycle
for research, development and procurement funding.
7. Encourage use of capital leases and operating leases for platforms.
Bundled operations, maintenance and logistics contracts would enable
customers to leverage imminent shortfalls in procurement accounts.
There is no legal prohibition against the Defense Department leasing
assets, such as tactical airlift, naval logistics and auxiliary
ships or transport trucks. However, capital leases (which are long-term
and have essentially all of the attributes of ownership) must be
funded with procurement dollars, while shorter-term operating leases
can be funded with operations and maintenance funding.
The Defense Department should focus on developing innovative leasing
arrangements with responsive contractors, or even third-party leasing
companies. Fiscal issues, contractual and personal injury/property
liabilities must be addressed and bundled into a coherent package
to generate long-term value for the customer.
8. Revise the cost principles in Federal Acquisition Regulations
(FAR) Part 31 and other regulations to maximize the profitability
of research and development work. This would make defense-unique
work financially attractive to companies, even if they never get
out-year production orders. Several “leap-ahead” technologies
endorsed by the new administration are inherently high-risk and
will only be “one-off” systems, such as national missile
defense, with no production or exports ever contemplated.