Perceptions of Defense Sector Undermine Financial Health

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.

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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.”

Topics: Budget, Export Control Reform, Procurement, Global Defense Market