Defense to be Regulated Much Like a Public Utility

The defense industry of the future is coming into focus, and the big takeover battle of Northrop, Martin Marietta and Grumman is only one step in a much larger consolidation. The next few years will see further mergers, acquisitions and dropouts to whittle down competitors in every type of weapon system.

We’ll get down to two military aircraft makers, say defense experts: Lockheed and McDonnell Douglas, backed by two big subcontractors, Boeing and Northrop, which today produces the B-2 Stealth bomber.

In military satellites, there are now eight suppliers, but later in the decade there will be only two or three, Keith R. Hall, an assistant secretary of defense, told Congress last year. Defense consultants figure Hughes Aircraft and Martin Marietta, and possibly TRW, will survive in the business.

In missiles, analysts name Raytheon and Hughes as survivors.

Some weapons are already down to a single supplier: General Dynamics is the nation’s only producer of tanks and submarines. And GD may sell the tank business to the subsidiary of FMC and Harsco Corp. that makes the Bradley combat vehicle, says analyst Richard Bitzinger of Washington’s Defense Budget Project.

Meanwhile, GD’s Electric Boat yard at Groton, Conn., is working on a contract for a Seawolf nuclear sub awarded by the Pentagon expressly to keep submarine capability alive in the United States.

The pattern is clear: Companies that are No. 1 or No. 2 in their specialty will remain in defense. Others will drop out.

Defense will still be a sizable industry, with companies enjoying more than $100 billion in annual revenues, fed by a federal budget for weapons procurement and research of close to $80 billion a year.

But the business will be changed. In part, defense will become a public utility--a regulated industry providing military weapons for the national defense for an allowable rate of return on investment, as other companies provide electricity, gas, water and local telephone service.

In other cases, when the Pentagon needs simple vehicles or airplanes to transport troops, it will buy commercial products--Jeeps from Chrysler, or MD-11s and 767s from McDonnell Douglas and Boeing.

That’s the outlook emerging from the first serious examination of an industry that was born in haste in the 1940s with the nation at war and in dire need of planes, tanks, ships and guns. U.S. industry received an emergency commission. “We cut a wide, rakehelly swath through the economy,” wrote Donald M. Nelson, chief of the War Production Board.

And it worked. Weapons were produced, technology developed. Then, to prevent a repeat of such emergency and to build on the technology developed in World War II, Gen. H.H. “Hap” Arnold of the Army Air Force and others created the defense industry we have known for the past 50 years.

Thanks to the Cold War, it was an industry that only rarely had to think of cutbacks. There were seven manufacturers of aircraft, for example. “If there was a problem, we threw money at it,” says one Pentagon consultant.

But when the Cold War ended, it became an industry with grievous overcapacity. Rationalizing that overcapacity is what the current shakeout is all about, says John Harbison, aerospace consultant with Booz, Allen & Hamilton.

Some saw it coming. C. Michael Armstrong, chairman of Hughes Aircraft, saw that his company--which is a division of General Motors--had missile plants working at only 35% of capacity. So he bought General Dynamics’ missile business, consolidated work at fewer plants and now operates missile production at 80% of capacity and has cut overall costs by 30%.

Others have done likewise. Lockheed, concentrating on aircraft, bought the fighter operations of General Dynamics; Loral Corp. has made numerous acquisitions in defense electronics.

Efficiency has brought global competitiveness. Defense exports, running at $30 billion in each of the past two years, have become big business.

Still, consolidation means shrinkage. When companies combine, they can immediately cut overhead by eliminating duplicate accounting departments, production facilities and so on. Defense employment has already fallen 30% to 900,000 and will fall another 20% from here, experts predict.

And a major change in Pentagon contracting philosophy is coming. With only one or two suppliers for individual weapons, there will no longer be effective competition. That’s why the Defense Department is contemplating a system under which the government will guarantee a contractor a certain amount of work, and a regulated rate of profit for doing that work.

It will not be a windfall business. As electric companies do now before public utility regulators, “contractors will open their books to the government,” says Robert Paulson, head of aerospace consulting for McKinsey & Co.

With that approach Defense Secretary William Perry hopes to improve on the present situation in which, by his estimate, 40 cents of every contract dollar goes for management and oversight rather than for actual engineering, research or production.

Just how good a business defense will be remains a question. “Yes, consolidating two companies can cut overhead, but you still have the problem of where new business is coming from,” says analyst Wolfgang Demisch of BT Securities. Military projects will be few and far between for the next 10 years and contractors on current work must fight for annual funding from Congress.

That’s why the stock market continues to accord premium prices to defense companies with a strong presence in commercial markets, such as Hughes, Rockwell and TRW.

Still, $80 billion a year for weapons R&D; and production is nothing to sneeze at. That’s why Northrop and Martin Marietta are fighting for a place in the defense industry of the future.