When the going gets tough, the tough return to fundamentals. That’s the case with the US aerospace industry today. To prevail in the current and expected turbulence, companies are analyzing the situation, separating fallacies from facts, and setting course for survival. Companies that don’t concentrate on such fundamentals will be increasingly vulnerable to failure.
Sorting out the facts and fallacies is essential not only for companies in the aerospace industry. Their customers—the defense establishment and the men and women of the armed services—need that understanding. So do those with mighty influence over the activities of the aerospace industry—Congress and the international financial community.
What fallacies need debunking, and what facts require concentration? One is often the obverse of the other. Let us consider a few current fallacies and determine the facts on the other side of the coin. With that done, we can look ahead to factors that are buffeting the aerospace industry now and that will for the next several years.
Fallacy: The defense business is more profitable than other commercial business; defense profits are “huge” by comparison. The facts are different. In a 1985 study called DFAIR, the Department of Defense concluded that defense contractor profits were generally comparable to those for commercial firms. (DFAIR stands for Defense Financial and Investment Review.) However, later studies by the General Accounting Office and the Navy differed, claiming defense industry profits were higher than the norm.
Which study was right? DFAIR, said the Financial Executives Institute (FEI). It is a professional organization of senior financial officers in more than 6,000 companies. The FEI evaluated all three profit studies and concluded that the DFAIR product was a sound piece of work. It said both the GAO and Navy studies had fundamental flaws.
However, looking at DOD acquisition policy changes, the FEI said, “The basic business equation is out of balance.” It says that recent policy shifts have thrown the business equation out of whack by “significantly increasing the contractor’s risk while eroding the potential return.” Furthermore, the recent poi-icy changes “threaten to disrupt the [former] business environment, which supported investment, promoted cost efficiencies, and encouraged competition.”
Both government and industry will be harmed by the consequences, the financial institute concluded. Major adverse effects include curtailing investment in new facilities and efficient production capabilities, shifting cash flow downstream by several years, eroding the US competitive position in the world market, and damaging the worldwide technology lead of the US defense industry.
Stock market behavior provides current-and valid-judgment on defense profits. If defense companies were hugely profitable, one would expect their shares to soar. In fact, during the extraordinary bull market of 1987, stock prices in defense companies underperformed. They did not run up to the artificial heights of other issues.
Fact: Media General Financial Services reported that for 1987 into mid-November, stock prices in its aerospace manufacturing group improved by eighty percent for all of 1987, compared with the Standard & Poor’s 500 index of 100 percent. Investors concluded that DOD policy to drive down profits made those stocks less attractive in the roaring bull market that preceded the crash. When the crash came in October 1987, stock prices of the aerospace companies fell about the same as the Standard & Poor’s 500 index, down thirty-two percent from the market peak on August 25 to the end of October.
Fallacy: Defense companies are “welfare queens” securely afloat on government largess. Wrong again. The basic business equation balances risk and reward. But in 1988, the potential returns on defense business are not commensurate with the increased risk. The equation is skewed, with more risk being shifted to the aerospace companies seeking defense business.
For instance, risk-shifting means that each of the two industry teams competing for the Air Force’s huge Advanced Tactical Fighter (ATF) program must share nearly half the risk of development as the price of admission to the contest. Each will incur costs of $400 million to $500 million more than the $691 million fixed-price contract they received. Even the winning team is not sure of recouping the money risked on the ATF venture. (The teams are Lockheed with Boeing and General Dynamics vs. Northrop with McDonnell Douglas.) That is risk with a capital R.
Losing Technology Lead
Such risk-shifting strategies may present an illusion of benefits now. However, there is potential for severe damage over the long run. In such a climate, technologically strong companies may be unwilling to take such extraordinary financial risks and may opt out instead. Cautious managers may decide to let someone else take the risks of development and bid for part of the production business when the unknowns are whittled down. That leads to technological stagnation.
US technological preeminence has been taken for granted since the days of the Kentucky long rifle. Experience in World War H and the decades that followed justified the belief. However, that comfortable feeling is no longer true. If the defense industrial base is not healthy enough for money to be available for investment in basic research and development, the stagnation can mean that some other country’s industry will make the breakthroughs that ultimately make the difference in battle. (See John Correll’s editorial, “Our Endangered Industrial Base,” in AIR FORCE Magazine, October ’87 issue.)
Fallacy: Fraud, waste, and abuse are rampant in the defense industry. High-priced hammers and toilet seats are part of contemporary mythology. Even knowledgeable legislators and officials have come to accept that fallacy. In fact, companies in the industry have detected and reported most of the alleged abuses, as they should. Defense companies must follow a higher standard than that of the letter of the law, because they are dealing with large sums of public money. In fact, the Packard Commission noted in its 1986 report that the aerospace industry was taking the lead in establishing programs of ethics and self-governance within its companies. Those programs are effective in meeting the higher standard required in the defense business.
Stanley C. Pace, Chairman and CEO of General Dynamics, told me how his company’s ethics “hot line” has worked out in more than a year and a half. Employees are encouraged to call the hot-line number with ways of improving the company’s ethical practices. Mr. Pace says that they have done that with tangible results.
But there has also been an unexpected and beneficial by-product. Employees began using the ethics hot line to put forth methods of improving production processes and for a host of other suggestions. The result: GD set up another hot line for suggestions. It now generates more than 450 calls per month, all of which are followed up. The number of calls to the ethics hot line has declined as the suggestion line’s volume has increased. Both results have been salutary.
Fallacy: Defense industry is cozy with the Pentagon. In fact, the Aerospace Industries Association (AIA) calls the current relationship “negative, adversarial rather than a partnership, with an underlying lack of trust.” Don Fuqua, twelve-term former congressman from Florida and now President of AIA, charitably attributes it to “legislative and regulatory overkill.”
DoD and industry certainly need to negotiate at arm’s length on contracts, but should cooperate as partners in executing the work. Instead, a lack of trust and a negative outlook pervade the current scene. Industry is presumed guilty, not the opposite. As Mr. Fuqua puts it, “We have lost the confidence of the nation.”
Fallacy: Fixed-price contracts are the way for the Pentagon to get the new products it wants. Fixed-price contracts make sense in certain situations, but are foolish in others. For volume acquisition of standard items, fixed-price contracting is valid and well established. In those cases, the basic development is over. The “unknowns” are known. The contractor can compete with others to calculate his costs. If he wins the business but exceeds the fixed price, that’s his problem. His profit or loss is related directly to his ability to control production costs.
For research and development projects, however, the use of fixed-price contracting is foolish. By definition, research and development deals with unknowns, advancing knowledge and technology. In signing the September 1987 revision of the basic procurement policy directive, Deputy Secretary of Defense William H. Taft IV said that fixed-price contracts for development are inappropriate. Industry sees that as a step in the right direction, recognition of the folly of fixed-price R&D contracting.
Fallacies are not easily dispelled. Facts seldom catch up. But the armed services and the aerospace industry must deal from facts, not fallacies, if the industrial base is to be preserved and strengthened.
Facts of Aerospace Business Life
Having examined current fallacies, it is now time to look at forces and trends in the international marketplace that affect US aerospace companies. Understanding these trends and their effects is essential to making sense out of aerospace corporate behavior in 1988 and the years ahead.
A few broad assertions are easily made. Clearly, flat or declining US defense budgets are here. The spending binge is over. In addition, the Department of Defense is a tougher customer than ever before.
A measure of nuclear arms limitations between the two superpowers is being achieved, emphasizing the need for conventional parity. Aerospace industry profits are being squeezed by forces at home and competition from abroad. Overcapacity in the global aerospace and electronics industries is leading to consolidation—acquisitions, mergers, and takeovers.
Competition the Key Word
All these forces can be summarized in one word: competition. They all intensify competition for US aerospace companies. Thus, in the views of many aerospace executives, the late 1980s and the whole decade of the 1990s will see a Darwinian struggle for survival of the fittest.
Take competition in the US defense business. For the Air Force, competition for the F 100 engines in its F-15 and F-16 fighters improved readiness and brought down unit prices. Through the same competition, General Electric’s engine group was able to achieve a significant increased market share, while Pratt & Whitney’s overall share dropped. Both engine companies got tighter and smarter in the process.
But not all competition for defense business—competition for competition’s sake—makes such sound sense. It is foolish competition if the “winner” cannot eventually make a profit. USAF’s competition for the Advanced Tactical Fighter may turn a profit for the winning team, but only after a long spell of red ink. In this climate, astute industry executives are having to decide whether to even enter competition for defense programs at all.
Why would an aerospace company strive for business that will not produce a profit? John J. O’Brien, President of Grumman, said his company was competing for the Navy’s Advanced Tactical Aircraft (ATA) in order to keep the business through the year 2000, despite the prospect of no profits on the program.
For example, if the Grumman-Northrop team had won the Navy’s ATA competition, Grumman would have needed immediately to add $100 million to its long-term debt to pay for the tooling and workers required. The company’s debt/equity ratio would have deteriorated, and its share prices might have fallen. Some victory. The engineering and production teams might remain intact, however, and Grumman should survive to compete for more profitable programs.
Elsewhere, Dan Tellep, Executive Vice President of Lockheed’s Missiles and Space Group, says the company is “not walking away from sensible bids,” but is not participating in senseless ones. And from St. Louis, Stanley C. Pace of General Dynamics defines the criteria for GD’s deciding to participate: “If GD has the technology and the customer has clearly defined, hard requirements.” If those conditions are not met, GD opts out.
Other CEOs echo that sentiment. Hughes Aircraft decided against bidding on the radar for the Advanced Tactical Fighter, concluding it would never recover the funds invested to compete, even if it won.
After the October crash, the market value of most listed companies dropped nearly thirty percent. (Market value is share price times the number of shares outstanding.) Companies whose share prices in early October were so high as to turn off potential buyers looked more attractive in November and December at discounts of twenty-five and thirty percent.
Companies whose share prices dropped significantly became more attractive takeover candidates after the crash. On the buying side, companies with large cash holdings began to take another look at takeover targets, seeking potential bargain buys.
Companies with strong cash positions took advantage of the sharp price crashes to buy back chunks of their own shares. That had two purposes—first, to decrease the shares available to potential raiders, and second, to demonstrate management’s confidence in their own companies to employees, shareowners, and the public.
Major aerospace companies conducted strong share buyback programs after the crash. Boeing bought back $600 million worth and Lockheed $300 million of its own shares. Rockwell International and Raytheon had been repurchasing their shares for some time before the crash. In electronics, Watkins-Johnson and E-Systems were among the firms to buy back their own stock after the crash.
Continued consolidation within the aerospace industry is the outlook, as weaker companies are absorbed by richer ones, both US and foreign.
At the end of World War!!, American aerospace products were the world standard, and the whole world bought them. In the late 1980s, American aerospace products are still technically sound. However, both civil and military customers worldwide have a multitude of sources from which to buy aerospace products.
One need only look at military trainer aircraft, for instance, to see the shift. British Aerospace’s Hawk trainer design will become the centerpiece of the US Navy’s aviator training system in the next couple of years as the T45 Goshawk. While using the Hawk as an advanced trainer, the Royal Air Force at the same time picked the up-engined Embraer Tucano design from Brazil as its primary trainer.
In commuter aircraft with nineteen passengers or fewer, the Brazilian Embraer Bandeirante design captured the US market from domestic aircraft manufacturers and then moved on to dominate the world market at that size.
Trainer and commuter aircraft are but two visible examples of foreign capture of former US markets at home and abroad. In deliveries of commercial wide-body jetliners, the European Airbus Industrie consortium more than doubled its share of the market from 1984 to 1987 (ten percent to twenty-two percent). Boeing held its share in the same period (forty-nine percent in 1984, forty-eight percent in 1987). However, McDonnell Douglas’s share of jetliners shipped dropped from thirty-two percent in 1984 to an estimated fourteen percent in 1987.
Seen another way, the overall pattern of US aerospace exports and imports has worsened. US aerospace exports have for decades made a positive contribution to the nation’s trade balance. In the 1960s, virtually no aerospace imports occurred; the export figures were the positive trade balance for aerospace. That began changing in the late 1970s, when the first billion-dollar aerospace import years occurred. By 1986, aerospace imports into the US totaled $7.9 billion, offsetting exports of $19.7 billion.
The trend is expected to continue, as US dominance of the world aerospace market is challenged and further diminished. Other countries have developed their own aerospace industries competitive with US companies technologically. Don Fuqua of AIA found that twenty-three countries now produce components for high-performance military aircraft. Numbers alone create intense competition for the business. Furthermore, in such countries as Brazil and Indonesia where solid aerospace industries have blossomed, the labor rates and government subsidies enable their products to beat US products on price.
Teaming and Joint Ventures
“If you can’t fight ’em, join ’em” is the old saying. That is happening in international aerospace at an ever-accelerating pace. Europeans have experience with forming multi- national consortiums to compete. Examples include the military Panavia Tornado aircraft and commercial Airbus transport. Executives with European aerospace companies maintain that their national markets are too small, and even regional markets are barely large enough. They form consortiums to gain access to several national markets with one program—as with Tornado and Airbus—while setting their sights on capturing additional markets outside the consortium.
Now, with more players in the international aerospace game, foreign companies are trying to penetrate the US defense marketplace. That places added pressure on US companies in two ways: to compete smartly to retain Defense Department business and to join with foreign companies to capture overseas sales.
For now, the most intense struggle is for the European jet fighter market of the 1990s and into the twenty-first century. The three countries in the consortium that built the Tornado (UK, Germany, and Italy) plus Spain have joined to produce the EFA, or European Fighter Aircraft.
At the same time, France is deciding whether to go ahead with development of its new fighter, the Rafale—either alone or with partners from Europe and the US. US industry and the Defense Department would like to see the Europeans select a derivative of the multinational F-16 (such as the Agile Falcon) or the F/A- 18 (for France vice the Rafale), followed by purchase of USAF’s Advanced Tactical Fighter (ATF) when it comes along in the mid-1990s.
As the smart aerospace companies concentrate on fundamentals for survival, Congress and the Defense Department should also stay focused. One of the bedrocks of US power and national security is its continuing technological lead. The nation must now grapple with the “twin towers” of budget and trade deficits. Tough economic choices are necessary for survival. In making the choices, the nation’s leaders must ensure that a healthy aerospace industry is retained. Otherwise, the world leadership enjoyed by the US for so long could slip away.
Profit Comparisons by Industry
|Industry Composite||Return on Equity||
Profits as a Percentage of Sales
|Electrical and Electronics||12.1||5.2||4.0|
|Office Equipment and Computers||11.5||7.9||6.7|
|Oil Service and Supply||-23.8||6.5||NM|
|Publishing and Broadcasting||18.5||9.6||10.5|
|Textiles and Apparel||12.9||5.2||4.6|
NM = Not material
Source: 1986 results: Business Week “Top 1000” (April 1987); Third Quarter results: “Corporate Scoreboard,” Business Week, November 16, 1987.
Acquisitions Targets in Defense Electronics
(June 1985—September 1987)
|Target||Acquisitor||Price (millions)||Price/Earnings||Price/Book Value|
|Lear Siegler*||GEC (UK)||205||23||NA|
|Lear Siegler**||Smiths Ind||350||17||NA|
* = 3 units of LSI
** = 2 units of LSI
NA = Not available
NM = Not material
Source: Phil Friedman, Drexel Burnham Lambert, Inc.
|Industry’s Big Ten Issues
In late summer 1987, the board of directors of the Aerospace Industries Association (AIA), whose members include more than fifty of the top aerospace companies, identified ten major issues on which the association should focus attention and action. They are:
• Financial health of the industry—maintain profitability and health.
• DOD-industry relations—restore trust.
• Legislative/regulatory overkill—micromanagement has impact on every phase of industry.
• Material requirements planning (MRP)—a mutual problem to be fixed.
• Independent research & development (IR&D)—artificial ceilings should be lifted to spur R&D.
• Eight key technologies for the 1990s—”must develops.”
• The race in space—rekindle American yearning to be number one.
• Quality and productivity—making the best aerospace products in the world.
• Ethics and self-governance—industry policing itself.
• Competitiveness in the world market—foreign competitors subsidized: US competing with one hand tied.
F. Clifton Berry, Jr., is a former Editor in Chief of AIR FORCE Magazine. He has written on international security topics for nearly twenty years. He saw USAF service in the Berlin Airlift, 1948-49. Later, he was a paratrooper and officer in the 82d Airborne Division. He commanded airborne and infantry units in the US and Korea and saw Vietnam combat as operations officer of a light infantry brigade. He is a principal in FCB Associates, an information service on international aerospace topics.