Subcontractors See Red When Looking at ATF
“The aerospace opportunity of the century” was how the defense industry once viewed the Advanced Tactical Fighter; a current assessment of the huge Air Force program is “the unprofitable millstone.”
Northrop and Lockheed, the two ATF prime contractors selected last year by the Air Force, are preparing to award major subcontracts on the $65-billion ATF program in the next several months.
As much as 75% of ATF revenue over the life of the project--about $48 billion--will filter down to subcontractors that build everything from navigation systems to ordinary rivets. Up to half of these subcontractors are thought to be located in Southern California.
But not all potential subcontractors are beating down the hangar doors of Northrop in Hawthorne or Lockheed in Burbank to try to get a contract. Uncharacteristically, the subcontractors are criticizing the terms of the program, and financial analysts are raising similar doubts about its profit potential.
‘Disaster Program’
“The ATF is a disaster program,” said David J. Smith, aerospace analyst at the investment firm of Alex. Brown & Sons. “The government is trying to get too much for too little and trying to get the industry to do it without rewarding them for it.”
What the Air Force wants from industry for the ATF is a quantum leap in jet fighter technology, providing supersonic cruising speeds and vastly improved electronic capabilities. At the same time, the service has set down an intimidating financial policy for those who will build the components of the plane.
The ATF game rules call for subcontractors to lose millions of dollars on their subcontracts for at least the next three years, in what is commonly called “cost sharing.” Under this policy, the value of subcontracts does not cover the actual cost of the work, so subcontractors must make up the difference and take a loss on the program, with the idea of earning profits when the plane goes into production.
The subcontractors may never get to production. They will have no guarantee that they will not be kicked out of the ATF program at the end of the demonstration phase and their technical drawings handed over to a lower-cost competitor. Even if they pass that hurdle, the same competition will occur again several years later at the start of the production phase.
“Some of these small companies are just going to say screw the ATF,” one official close to the program said.
It is still too early to tell whether subcontractors will refuse to bid on ATF work, but some defense subcontractors are clearly taking a cautious approach to bidding on the project.
An indication of that came just recently when both the Northrop and Lockheed teams awarded subcontracts for the ATF radar to a team of Westinghouse and Texas Instruments, rejecting bids by the team of Hughes Aircraft and General Electric.
Although it appeared to be a surprising double loss for Hughes, which has been a leader in jet fighter radar, Hughes apparently was fully prepared to lose the competition.
“We believe we knew the amount of investment it would take to win the program,” a Hughes executive said. “When we penciled that out, it didn’t make economic sense. We did not bid to that level. We made a business judgment.”
Hughes declined to disclose the value of its bid, but the executives said they believed that Northrop and Lockheed were seeking dollar-for-dollar cost sharing, meaning that the value of the contract would cover only half of the tens of millions of dollars it will take to develop the radar.
“To make a substantial investment and then be subject to recompetition, to have no assurance we would be on the winning team, to have no assurance that we would be able to recover our investment did not seem to be a good business decision,” the Hughes executive said.
“It looked like the break-even point was so far out in the future that it did not make sense to bid this to a level that would have won the contract,” he added. “We felt the conditions were not fair.”
Losing Technology Base
The Hughes assessment of the ATF program seems to confirm the worst concerns of some experts who worry that the Pentagon’s efforts to force cost sharing will have grave long-term consequences.
“The long-range effect is that you are sending the technology base down the tubes,” said Michael N. Beltramo, a defense procurement consultant and former Rand Corp. researcher.
If it were not for cost sharing, Beltramo said, both Hughes and Westinghouse would probably still be involved in the ATF program. But “now, with cost sharing, we will be getting only one contractor,” he said. “It is going to hurt our national security base.”
Smith, the aerospace analyst, went further, saying: “There is no way the United States Air Force is going to be able to take this program and shove it down industry’s throat. The destruction of the defense industrial base is what is going to be left in the aftermath.”
Edmund Dews, a defense procurement expert at Rand, termed the sharply increased risks and reduced rewards of the new Pentagon policy “an extreme swing of the pendulum.” While the defense industry has excess capacity at the prime contractor level, it cannot afford to alienate subcontractors, Dews said.
“It will cause some of the subcontractors to object or withdraw,” he said. “If they withdraw, it has the potential of reducing the size of the defense industrial base.”
But Lockheed and Northrop, the prime contractors, have little choice but to seek as much cost sharing as possible, because they have gone far out on a limb themselves in cost sharing.
Both teams are working under 50-month contracts valued at $691 million each, but those contracts are woefully short of the actual cost of fulfilling the Air Force’s requirements.
Burden Is Uneven
The contracts in the program’s first phase, known as the demonstration/validation phase, are likely to cover only 50% of the costs, according to Albert Piccarillo, the recently retired Air Force ATF program manager.
In addition, the Air Force will not pay the $691 million in equal installments. The payments are “back loaded,” meaning that more of the funds will be paid toward the end of the program than at the beginning, forcing the contractors to finance the work themselves in its early stages.
Piccarillo best summed up the Air Force strategy toward industry cost sharing when he suggested that the Air Force will “force them to play until they scream and fight and refuse.”
In a similar way, the prime contractors will drag cost sharing out of their suppliers, despite some kicking and screaming.
“Nobody is going to be a subcontractor to either team without doing significant cost sharing,” said Sherman Mullin, Lockheed’s ATF program director.
Marvin Elkin, Northrop vice president of materiel, expressed the same view when he said in an interview: “We are cost sharing and we want them to cost share on the same basis. We had a supplier symposium. We told them some of the ground rules, and cost sharing is going to be a determinant in this program. That is a way of life.”
Obviously Northrop and Lockheed have a big incentive to get as much cost sharing as possible from each subcontractor. “It will affect our bottom line, (depending on) how good a negotiator we are,” Elkin acknowledged.
Playing Greater Role
Those negotiations are now entering the critical phase. Northrop and Lockheed expect to issue the preponderance of ATF demonstration/validation subcontracts between May and August, including those involving such major systems as electronic warfare, communications, mission (computer) processor, cockpit display, flight control, electrical, fuel and landing gear, among many others.
Subcontractors will play a more important role in building the ATF than has been the case with any other jet fighter because the prime contractor’s job of building the airframe is becoming less important and integrating all the electronic systems on a jet fighter is become far more important. In the aircraft business, the airframe work is often put down as “metal bending.”
Metal benders on jet fighters 10 or 15 years ago took about half of a program’s revenue, Elkin said. That will go down by 15 to 25 percentage points on the ATF.
Mullin estimated that, if Lockheed wins the competition, 75% of the value of ATF over the life of the program will be subcontracted out, leaving 25% to be split among Lockheed and its two team members, Boeing and General Dynamics. Lockheed will build prototypes of the ATF in Burbank, but full-scale production would be based at its facility in Palmdale.
Elkin, meanwhile, estimated that 65% to 70% of total ATF revenue would eventually flow down to subcontractors if the Northrop team wins the production contract, leaving the balance to be split between Northrop and its teammate, McDonnell Douglas. Northrop will build its ATF prototypes in Hawthorne.
No matter who wins the production contract, the program will create tens of thousands of jobs across the country, many of them in Southern California.
Want to Participate
Despite the concerns by the subcontractors, Elkin believes that most firms are willing to participate in the ATF program.
“There has been a lot of grousing in the industry. They don’t like it, but they understand it and they want to participate in the program,” Elkin said. “A whole lifetime is going to pass him by if he isn’t on ATF.” That is exactly the sentiment that the Air Force hopes will compel subcontractors to flock to bid on the ATF program.
“We would rather not cost share, but for a program that will be 1,000 airplanes, we want to play the game,” acknowledged Frederick G. Deragon, Garrett Corp. senior vice president of sales and marketing.
Garrett, the Los Angeles-based unit of Allied-Signal, builds such things as environmental control systems, computers and hydraulic systems. Typically, every F-14, F-15, F-16 and F-18 carries about $500,000 worth of Garrett equipment.
Deragon said Garrett plans to bid for several large systems on the ATF, but he is worried about financing development under the cost-sharing policy. “We are not a bank,” he said.
“The tough thing here,” he went on, “is that they want to keep two (companies) on contract right through demonstration/validation. That’s a terribly expensive way to do it. “We will bid and then if we are lucky enough to get everything on both teams, we would have a tough decision to make. We would have a hard time affording it.”
Deragon is especially worried about the prospect that Garrett would pour corporate funds into the ATF and then one of its competitors--Hamilton Standard or Sundstrand, for example--would take the program away in later competitions.
Contains Many Risks
“If you win, you might not win,” Deragon remarked. “This is one of the things that causes you to take a hard look at your investment. How much investment should you make against the various scenarios?
“What if they cancel the program? Then the guy who didn’t bid is fat, dumb and happy. Suppose one of the two teams doesn’t do well and they accelerate the program and go with subcontractors already on the program?
“We have to be pretty smart to figure all of this out. You really can’t. If we tried to pick the winning team, we would probably be wrong.
“We don’t know what the government is going to want. A congressman four years from now may have a contractor in his district who wants a piece of our business,” Deragon added.
Air Force officials hear this criticism, but they have no plans to alter their strategy.
“The problem I have with the grousing is that it is all speculative,” said Anthony DeLuca, the Air Force’s deputy competition advocate general. “When I hear an analyst say this program is a catastrophe, I have to take that with a grain of salt.
“From our standpoint, things are looking pretty good. We have two solid teams in place,” DeLuca said. “If we perceive things are going awry, we will take action.”
Piccarillo, the retired Air Force ATF manager, said: “There is a feeling that there have been giant profits in the last six or seven years, so let’s get some of that put to use. In a period of declining budgets, the Pentagon is looking at all kinds of techniques to get these systems built. Creative financing is what they call it.”
But Wolfgang Demisch, aerospace analyst at First Boston, believes that such creative financing methods as cost sharing on the ATF threaten to make the program an “unprofitable millstone.”
“Why commit suicide?” Demisch said. “Will contractors explicitly not bid? I hope so. People will not accept totally unreasonable contracts.”
Despite such warnings, Air Force officials do not expect contractors to purposely avoid bidding on risky development contracts and wait to bid on production contracts.
Would Gain an Edge
“That is a risky game to play,” DeLuca said. “You are betting on the come--and that is a very dangerous thing to do. We don’t want to create an industry where we have a bunch of firms out there licking their chops for production contracts.”
Elkin, the Northrop vice president, added that an early role in the ATF will be a clear advantage in bidding for later production contracts, even if there is competition.
“If a contractor has his footprint on a system, he is going to have a leg up to bid,” Elkin said. “He is going to have an advantage in the long run.”
But the record seems to show that in recent years some aerospace contractors, such as Raytheon, have been enormously successful at concentrating bidding on production contracts and avoiding risky development programs that become financial black holes.
Hughes officials say they ultimately may attempt to get back into the ATF radar program when it is reopened to competitive bidding. “We are not going out of the radar business,” the Hughes executive said. “We are not going to stop pursuing the technology of the ATF radar.”
