Industry Study Claims Reforms Will Weaken Defense Sector

Half a dozen major defense procurement reforms during the last three years, which have increased financial pressure on contractors, will result in a “serious weakening of the U.S. defense industrial base,” according to an industry-funded study released Tuesday.

Among its most important findings, the study claims that the six key financial rule changes, which grew out of defense scandals, will require contractors to take on additional financing amounting to 50% of their net worth.

That will amount to $8.5 billion for just the nine companies that participated in the study, which was conducted by the MAC Group, a management consulting firm in Cambridge, Mass.

Top industry executives and trade association officials met with Defense Secretary Frank C. Carlucci on Monday to present the findings and apparently enlist support for returning to the old rules or obtaining some other relief.

The procurement reforms imposed by the Pentagon and Congress in recent years have evoked an outpouring of wrath from defense contractors, but the trade group study is the first serious effort by the industry to assess the overall effect of the changes.

“We have increased the risk and lowered the potential for reward,” said Don Fuqua, president of the Aerospace Industries Assn., one of three trade groups that sponsored the study. He predicted that the net effect will be either a reduction of technical capability in the industry or an exodus of companies from the business.

The study declined to identify the participants but described them as nine major companies representing 24% of the Pentagon’s prime contract awards in 1986.

“The companies did not want to be identified because there was a concern that their stock would go down,” one industry official remarked. “Even if the industry is going to pot, they all like to think their own companies are different.”

Additional Borrowing

At issue are six key financial changes that affect the industry’s financial structure and that will result in massive borrowing over the next several years in an industry that has traditionally had little debt.

The additional borrowing is being driven by highly technical changes in regulations that have reduced the amount of financing that the government provides for work in progress, tooling and tax liabilities.

For example, the government used to allow contractors to defer payment of corporate income taxes until a contract was completed. But now companies must pay about 70% of their taxes as they book the profits. That has speeded up tax payments, resulting in the need for financing.

Another example involves the Pentagon’s practice of paying a contractor for progress toward completion of a contract. Formerly, such payments covered 90% of the contract value prior to delivery but now contractors receive only 75% of the contract value and must deliver the product to obtain the balance.

To make up for the shortfall in government financing, the industry will have to increase its reliance on borrowing. Since interest costs are not reimbursable, this represents another drain on contractors.

“We are faced with an untenable situation,” said David Koonce, project director for the study at the Aerospace Industries Assn. “We have something bigger than we can handle and, if we don’t change course, we will have a heck of a problem.”

Study ‘Assumes No Change’

Joseph Campbell, a securities analyst at the investment firm of Paine Webber Inc., said the report “is a fair and accurate assessment of what could happen in the future.”

“It is conservative,” he said. “It is really much worse. Until now, nobody has published a comprehensive report that laid out the meaning of these hodge-podge changes.”

Campbell noted, however, that the study assumes that companies will not be able to change.

“It assumes that people behave under the new rules the same way they did under the old rules--a big assumption,” he said. “Will contractors behave differently in a risky environment?”

Fuqua of the Aerospace Industries Assn. agreed that companies will either drop out of the industry or consolidate before the scenario depicted in the study manifests itself. But he hopes that the reforms will be countermanded before then.

Fuqua said Carlucci “seemed to be very sympathetic to the potential problem the industry is facing.”

1984-87 DEFENSE PROCUREMENT REFORMS

Below is a summary of MAC Group findings. Cost-sharing provisions: Contractors are now frequently required to pay a part of a contract’s research and development costs, even though another contractor might be selected to produce the resulting product.

Profit policy adjustments: Program profit markups have been reduced by about 1% of costs.

Changes in progress payment rates: The percentage of work in process covered by interest-free government financing has dropped to 75% from 90% or more.

Special tooling investment recovery: Contractors must capitalize and amortize investments in special tooling required to make unique products. Previously, expenses were reimbursed when incurred.

Lower cost recovery: Travel and per diem costs in excess of government limits are no longer allowable as contract costs and must be deducted from contractors’ profits.

Tax law changes: The industry has traditionally deferred tax recognition of profits until the end of a contract. Tax law changes have ended about 90% of the deferral, resulting in faster tax payments.

Los Angeles Times