Fallacies and Facts About Aerospace

Feb. 1, 1988

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.

Fallacies Abound

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.

Market Response

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.

Takeover Situation

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.

Foreign Competition

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

(Percentages)

Industry Composite

Return on Equity

Profits as a Percentage of Sales

(Twelve Months)

1986

Third Quarter

1987

Third Quarter

1986

Aerospace

9.6

3.5

3.0

Appliances

14.9

4.4

4.8

Automotive

14.2

3.9

2.5

Conglomerates

10.1

6.7

NM

Drugs

21.2

12.9

12.1

Electrical and Electronics

12.1

5.2

4.0

Food Processing

19.0

4.2

4.3

Metals/Mining

5.4

9.6

3.4

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

Retailing, Nonfood

14.2

2.5

2.3

Steel

-28.0

3.2

NM

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

ARGO Systems

Boeing

$275

27

5.0

Dalmo Victor

Singer

174

21

NA

Electrospace

Chrysler

367

21

6.3

Goodyear Aero

Loral

588

18

NA

Hazeltine

Emerson

189

NM

3.4

Hughes Aircraft

GM

5,700

35

5.0

Lear Siegler*

GEC (UK)

205

23

NA

Lear Siegler**

Smiths Ind

350

17

NA

Sanders

Lockheed

1.200

NM

3.3

Sperry Flight

Honeywell

1,025

23

NA

Tracor

Westmark

694

21

2.5

Median

21

3.4

* = 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.

Source: AIA

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.