Viewpoints : Downsizing America’s Defense Industry
Ford Motor Co. this month announced a major change in corporate strategy by choosing to sell its Ford Aerospace unit and exit the defense business. The move followed a similar announcement a month earlier by Chrysler to sell its aerospace operation.
Both moves recognize a growing problem that, if not adequately dealt with by other defense contractors, could result in serious harm to our military production capabilities, aerospace work force and technological competitiveness.
The problem, in a nutshell, is that there are simply too many defense companies chasing too little defense business. If companies don’t merge or initiate creative joint ventures to proactively reduce capacity in the near term, they will be further weakened by their debt loads at a loss to shareholders and employees. In the interim they need to maximize use of their existing assets by improving cash flow. This includes selling unproductive assets, such as real estate, that aren’t part of their basic businesses, reviewing options for pension overfunding and aggressively managing working capital.
If not, as the stock market overreacts to “peace breaking out” by rapidly pushing down the value of defense stocks, there may be a window of vulnerability to takeovers of defense firms through leveraged buyouts, as has recently been the case in other consolidating industries such as retailing or airlines.
After years of serving the country well, a haphazard breakup of the industry wouldn’t be good for our overall defense posture or for U.S. technological innovation, which relies a great deal on the work of our defense firms. Many products or advances such as composite materials, digital communications, lasers, advanced electronics and space systems trace an important part of their technological roots to military programs.
Why is there not enough business to go around?
The defense business has always been cyclical. But reduced tensions in the Eastern Bloc and continued high U.S. budget deficits have resulted in pressures to cut the American defense budget on a longer-term basis. As budgets decrease and current order backlogs work off, as they will in the 1990s, a large number of defense firms may have to get out of the business, and the ones that remain will face an extremely challenging contracting environment.
Even if budgets were stable, there would be overcapacity. That is because the nature of our defense programs is vastly different from a decade ago. Today, military programs have become more complex in design and smaller in number. Whereas in the past we would build five planes or five missiles capable of fulfilling five roles, we now build only one plane or one missile to fulfill five roles. That means fewer pieces of the action for fewer contractors.
Also, the financial returns on defense business are falling. Delayed payment schedules and the growth of fixed-price development contracts--in which firms must perform work on a fixed price and absorb a share of losses if costs rise--have shifted more of the financial risk to contractors.
These and other problems have been reflected in the declining stock prices of defense contractors. Shareholders have seen the firms’ market value fall dramatically in the past two months. A composite index of defense companies, for example, is currently trading at a discount of over 30% on Standard & Poor’s 400-stock index of industrial firms.
Fortunately, there has been some realization among defense firms of the need to consolidate. One manifestation of that is through “teaming” relationships on such programs as the Advanced Tactical Fighter. In that program, a team comprising Boeing, General Dynamics and Lockheed is competing against the team of Northrop and McDonnell Douglas. The thinking is to spread the financial risk in a difficult environment and keep more contractors involved, albeit with a smaller piece.
The problem with that approach, however, is that you don’t really reduce overall capacity. In some cases, each team member focuses on a specific expertise, but in many others, their capability of performing multiple roles is still maintained. Instead of feeding everybody a full meal, they try to get by giving them half a meal. That may be a short-term transitional fix, but it will result in malnutrition in the long run unless defense firms--large or small--merge or otherwise reduce capacity.
European defense firms out of necessity realized the need to merge or divest long before ours and are well on the road to consolidation. Rather than plodding along in a declining domestic business, European companies--well in advance of the 1992 framework for cooperation--have seen the need to consolidate efforts with former competitors. They have moved past the stage of successful teaming relationships and have announced, at an increasing pace, large acquisitions such as West Germany’s Daimler-Benz buying Messerschmitt-Bolkow-Blohm, or the British-German GEC-Siemens acquiring Britain’s Plessey. They have also pursued mergers or joint ventures, such as France’s Aerospatiale with Alcatel in satellites and British Aerospace with France’s Thomson-CSF in missiles.
But U.S. firms generally have been reluctant to follow this path. Why?
Partly it’s because during the Reagan Administration military buildup, they were not encouraged to do so. A large base of contractors put pressure on each other to assume greater risks and bid aggressively, motivated by the need to keep capacity on line and the fear of missing milestone programs and thus being left out of a generation of technological advancement. This process increased the role of contractors as bankers, helping to finance the buildup. So long as the defense budget dollar pool was rising, this system managed to keep a large base of contractors afloat.
Now with the prospects of fewer defense dollars to spend, the government is effectively forced to say to those in-debt contractors, “Sorry, I’ve lost my high-paying job and can no longer afford the mortgage payments on that expensive home you’re building for me.”
Firms have also relied on growth in the commercial sector of the aerospace industry to balance their risk. But as the experiences of Boeing, McDonnell Douglas and Lockheed in the mid-1970s or early 1980s painfully showed, their commercial aerospace businesses were not immune to cyclical vagaries. Even now, airline stocks have started to tumble after an active year of consolidations, hinting at the possibility of cancellations of future orders. And Europe’s Airbus Industrie has become a formidable competitor in this previously U.S.-dominated market.
Firms may also hesitate in following the merger path out of a perception that the Pentagon, concerned about reduced competition, won’t allow large-scale consolidations. Many companies in fact have believed that Defense Department concerns would shield them from hostile U.S. takeover bids while the Exon-Florio Amendment, requiring presidential review of foreign takeovers of U.S. technology-based companies, would act as a similar hindrance for overseas buyers.
History has shown, however, that the Defense Department has taken a relatively passive role in merger cases. And as uses of Exon-Florio indicate, a surprising number of foreign acquisitions have been permitted with only some minor tinkering on financial terms.
By the mid-1990s, the U.S. aerospace industry will look significantly different. A period of consolidation will have dramatically reduced capacity. With the proactive consideration of industry participants, this process can be managed to create companies that are strong international competitors. If not, the process may unfortunately be characterized by a higher level of bankruptcies, writeoffs, layoffs and financial arbitrage opportunities.
