BusinessWeek: January 10, 2000

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Commentary: Reveille for Government Arsenals?

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Commentary: Reveille for Government Arsenals?

CHART: Fewer Bucks for the Bang


With apologies to William Tecumseh Sherman, it's peace that is hell--for the American defense industry. Downsized in response to shrinking Pentagon budgets, the arms complex has dwindled to a handful of ungainly conglomerates--many beset by giant bottom-line problems. Stock prices of Lockheed Martin Corp. and Raytheon Co. hover near 52-week lows as earnings disappointments pile up. Bonds of defense contractors verge on junk status. "If the industry cannot raise the capital it needs," Credit Suisse First Boston analyst Pierre Chao warned in a Dec. 7 memo, "then the U.S. could have a national security problem."

The outlook is so grim that it may be time to think the unthinkable--transforming today's companies into regulated utilities. It's a drastic approach. But with too many companies chasing too few defense dollars, analysts warn of an impending "death spiral" as companies find their costs of capital soaring amid shrinking revenues.

The Defense Dept. has some ideas for new ways of ensuring competition that, it says, can head off this doomsday scenario. In January, the Pentagon's acquisitions czar, Jacques S. Gansler, is expected to unveil such nostrums as giving research and development funds to losers of competitions for big contracts--an idea with some support among politicians.

But modest tweaks won't work. Nor will letting industry consolidation simply proceed on a more global scale: U.S. military hardware is far ahead of what European suppliers make, and the rules governing transfers of military-related technology overseas are so restrictive they would quash most transatlantic deals anyway.

What's needed is a radical rethinking of the way we arm the nation. That's where the public utility/arsenal concept comes in. Under this arrangement, arms makers would become investor-owned arsenals with a guaranteed rate of return and a predictable share of Pentagon contracts.

Sounds impractical? There is ample precedent. After all, government arsenals and shipyards were the core of arms production from the nation's founding until the 1940s. At 1.6% of gross domestic product in 1940, defense was just too small to sustain a defense industry. At the end of the war, that was no longer the case, and during the decades of the cold war it rarely dipped below 5% of GDP. By the time military spending peaked at 11.7% of GDP in 1953, the U.S. had a massive military-industrial complex with healthy competition and happy investors.

But the system grew shaky when the Berlin Wall collapsed. Pentagon-driven consolidation propped up share prices--but only for a while. Today the defense budget is 3% of GDP and dropping, and procurement spending is off nearly 50% from the 1987 peak of $110 billion. Competition is now a sham: Raytheon has monopolies on tactical missiles, and Lockheed Martin has one on anti-sub weapons.

For market solutions to work, defense contractors need a real marketplace. That means product cycles short enough to allow shifts in suppliers, demand enough to support competitors, and Darwinian competition for contracts.

BOOMER FACTOR. None of these conditions pertain. Lose a major contract, like McDonnell Douglas did with the Joint Strike Fighter, and you're out of luck for 30 years. Moreover, there are no innovative startups clamoring to be defense contractors. The situation is likely to get worse in a decade or so, as retiring Baby Boomers' clamor for increased Social Security and health-care spending brings added pressure on the defense budget.

The military has been trying to preserve the illusion of competition--and keep more companies in business--by divvying up contracts. That's hardly a solution. If companies know they'll get a piece of the action, they have little incentive to submit a truly competitive bid. And getting only some of the work can mean red ink--even for the "winners."

Better then to consider the utility model. Start by taking consolidation to its logical end, creating monopolies in a host of product lines. Next, force the divestiture of commercial businesses, which have often been costly distractions from the core businesses anyway. Shrinking these companies will also make them more manageable.

It's not such a huge step from where the industry is now. Cost-plus contracts already cap industry returns, the way that rate-of-return rules used to cap Bell operating company earnings. And Pentagon auditors already pore over defense contractors' books.

The big difference is that if the process were formalized, companies would be guaranteed a stream of revenues. Right now, the rewards are limited, but the risks, as McDonnell Douglas investors found out, are huge. That's not attractive to investors. If both rewards and risks are limited, defense contractors could become the sort of safe, countercyclical investments that utilities used to be.

"PRIVATE ARSENAL." Another goal would be to create a sort of military Bell Labs within the arsenal companies to do the research to keep the U.S. military on the cutting edge. "What we need is a private arsenal system," says Herbert L. Fenster, a veteran defense industry lawyer. Whether we like it or not, he adds, such a transition "is happening before [our] eyes."

If a major threat emerges in decades to come and defense procurement rises, other companies will want in. Then the U.S. can consider deregulating defense again. After all, it was only when it was clear that telecommunications would evolve into a dynamic, competitive industry that deregulation made sense. At this point, the defense industry, now a cold war dinosaur, shows no such signs. Without a new approach, its extinction is inevitable.

By Stan Crock

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