Defense Industry’s Real Problem: Capricious Pentagon

Article Published in the Aviation Week and Space Technology

The Pentagon is sponsoring a study by the Defense Science Board (DSB) to figure out what has gone wrong with the defense industry. In the two years since senior policymakers blocked the merger of top-ranked military supplier Lockheed Martin with number-four Northrop Grumman, investors have deserted the sector. Even contractors with excellent earnings growth such as General Dynamics have seen a third or more of their market capitalization evaporate.

Pentagon policymakers are concerned that the market meltdown may impair companies’ capacity to raise capital and attract talent. The Defense Science Board study is supposed to signal this concern by identifying ways in which the industry’s business outlook can be bolstered.

Anyone who has followed DSB deliberations over the past several years knows that task forces on politically touchy issues tend to be stacked decks. Charters are written and participants selected to assure that policymakers will find the final report reasonably congenial. So it is with the “Defense Science Board Task Force on Impact of DoD Acquisition Policies and

Practices for Health and Competitiveness of U.S. Defense Industry.” As the name suggests, the study will not examine the full range of relevant Pentagon policies but instead be confined to such arcane issues as price-based contracting, cost accounting standards, and level of source-selection authority. These things matter, but they don’t get at what is really troubling the defense industry.

The real problem – – the problem that transcends the idiosyncrasies of specific companies – – is depressed demand and an unreliable customer. During the Clinton years military procurement spending has fallen to the lowest level in living memory: 3% of the federal budget, 0.5% of gross domestic product. Procurement is the main source of industry profits, and the Clinton

Administration has consistently failed to meet its own targets for procurement spending. The $60 billion it is requesting for fiscal 2001 is a third less than the Congressional Budget Office says is needed to sustain the administration’s preferred force structure.

That’s bad enough for an industry that only has one customer (the Pentagon). But what really damages industry credibility with investors is the capricious, unpredictable way in which the government shifts procurement dollars around from year to year, undercutting business plans and earnings projections.

Policymakers don’t understand the damage such turbulence causes. That was brought home to me last year when I complained to a senior Pentagon official that, in the run-up to the fiscal 2001 budget request, planners had altered the funding profile for every category of warship in the Navy’s shipbuilding program. His response: “We do that sort of thing every year in the shipbuilding budget.”

Exactly. And since shipbuilders get 90% of their revenues from the Navy, there’s nothing they can do about it, right? But there is something investors can do, and they have been voting with their feet.

Similar obtuseness among policymakers is apparent in the aerospace portions of the procurement budget. Consider three examples:

* The Joint Strike Fighter is expected to be the biggest military-aircraft program in history. Thousands of planes, hundreds of billions of dollars. Almost every other tactical aircraft disappears from the out-year budgets to make room for it. So if a company doesn’t have a role in JSF, it probably doesn’t have a future in the military-aircraft business. Nonetheless, until two months ago senior officials persisted in the destructive fantasy that the entire program would be awarded to one company. What message does that send to investors about the risks involved in owning defense stocks?

* Another example: the Airborne Laser is one of the very few revolutionary weapons under development that is on time, on budget, and facing few technical problems. It has an urgent military mission that currently isn’t being met. But the program’s first test shot has been delayed two years due to a funding cut. Why? Because a senior defense official wanted to teach the Air Force a lesson about mis-spending money in a totally unrelated area. What message does this send to industry about the role of merit in policy outcomes?

* A third example: the C-17 is the best jet transport aircraft ever produced, and the Air Force has acknowledged that fact by making a multiyear commitment to its purchase. But now the Pentagon wants to cut back the number of planes to be produced in 2001 by 20% and claims British orders will make up the difference. This sounds a lot like the European buy of six JSTARS planes that supposedly justified a cut in the U.S. purchase from the required 19 aircraft to 13. The European buy never materialized, but the Pentagon failed to restore funding for the 19. What message does this send about the reliability of Pentagon commitments?The pending Defense Science Board study will probably produce some useful findings, but it won’t get at the heart of the industry’s troubles. The real problem is a Defense Department run by people with too much ideology and too little business experience – – people unwilling to commit adequate money to modernization, but all too willing to backtrack on the few long-term commitments they have made.