Defense Industry Models Must Change to Draw New Investors.

For decades, we referred to the "defense-industrial complex" as if contractors were merely captive extensions of the Defense Department. It is clear, however, that last summer's Wall Street abandonment of traditional aerospace and defense stocks and the current debate over the potential cancellation of several high-visibility programs call for the creation of a new "national-security business" model.

That model must integrate the long-term needs of the nation's defense with the shorter-term scrutiny of shareholders on Wall Street.

Two messages should be made clear during the ongoing Quadrennial Defense Review by the Bush administration. First, the Defense Department must have a robust long-term defense industrial base to support the administration's strategic objectives, such as a national missile defense, tactical air superiority, precision-strike and deep-strike capabilities, tactical airlift, command and control, as well as airborne surveillance and jamming.

Such focus drives the need for "leap-ahead" technologies in key areas. However, breakthroughs in critical "leap-ahead" technologies endorsed by the administration are tied directly to defense-unique subsystems and stand-alone technical capabilities. Specifically, it is less likely that major breakthroughs in these "leap-ahead" technologies will occur at the platform level. Rather, such breakthroughs are much more likely to occur at the subsystem level, such as electronic countermeasures, fire control, sensors and integrated communications, among others. This is a fundamental shift from the traditional philosophy that focused on plat forms, not subsystems.

Second, the defense industrial base must be well capitalized, in order to drive those breakthroughs in "leap-ahead" technologies. Given the cost-accounting structure of government contracting, contractors in defense-unique, research-intensive areas must have constant capital infusion, via issuance of stock or debt, to develop new areas of technical expertise or even to capitalize substantial portions of the front-end of major production programs. There is a direct correlation between the ability of contractors to get access to capital and investors' perceptions of the ability of those contractors to generate reasonable return-on-investment.

Shorter-term "value investors" will accept strong cash flow and reasonable profit, even in a mature industry with such limited top-line growth, so long as there is "controlled-risk." Simply put, from an investor's perspective, the immediate value of a particular stock is a function of current corporate assets, plus the projected future "value" of the company. This is at the heart of almost all stock-valuation models. But while projected top-line growth will have a proportionate effect on future "value" projections, risk has a much greater adverse impact on stock valuations. Consequently, true value investors often will invest in undervalued companies with strong business fundamentals and controlled-risk-even with modest growth in projected sales--over companies with large growth potential, but major risk, as in the "dot.coms."

While many government officials support increases in defense spending, the future of the Pentagon's budget cannot be predicted. Under the Bush administration, defense dollars are competing against tax cuts, and reforms in Medicare, Social Security and education.

Nevertheless, literally billions of dollars can be capitalized by shareholders in a true controlled-risk environment. This requires consensus between key government leaders, shareholders, and industry management on a clear approach to generate a reasonable annual return-on-investment with con trolled-risk.

Government officials, industry management and shareholders should work hand-in-hand in the following areas:

* Completing the long-overdue consolidation of the excess capacity in the mid-tier defense industrial base.

* Establishing clearly-understood risk-to-reward relationships with responsive contractors.

* Generating shareholder confidence of reasonable return on investment, in a con trolled-risk environment.

Following are examples of decisive actions needed to create a more investor-friendly environment for the defense industry:

1. The Pentagon should selectively reassess acquisition strategies in on-going "winner-take-all" competitions, such as the Joint Strike Fighter, to rejuvenate the anemic industrial base. Almost the entire future fighter market soon will be determined by a single down-select. This affects competing contractors' ability to raise capital, because stock models directly compute current stock price as a function of both future growth and future risk. Such imbalanced risks warrant careful analysis of alternatives, such as leader/follower or "competitive split" (winner takes the most lucrative subsystems). The industry also should validate the cost/schedule impacts that would result from restructuring those major programs.

2. Given the irrevocable Defense Department commitment to "bundled" platform competitions, subcontractors must complete the long overdue mid-tier industry consolidation. This is critical, because there generally are only two prime contractors for most platforms, such as fighter aircraft, and there is only room for one subsystem subcontractor on each competing team. After final down-select, only one subsystem may eventually go into production, if ever.

3. Reshape antitrust evaluations to ensure that future antitrust evaluations also incorporate the Defense Department's clear commitment to an integrated U.S./NATO defense industrial base. There are a large number of defense-unique, research-intensive subsystem markets that still require extensive consolidation to generate research and development "critical mass," while shedding major pockets of excess production capacity.

4. Restructure troubled "legacy" programs. When a healthy contractor acquires a less competitive contractor, it usually inherits at least one or more troubled "legacy" programs with major technical, schedule and financial difficulties. It is vital to immediately identify such troubled "legacy" programs for restructuring with the customer, to ensure that additional management, technical and financial resources are allocated to fix schedule slip-pages and technical problems. This is at the heart of controlled risk: ensuring that the government, industry and shareholders all have a clear understanding of the risk-to-reward relationship in troubled legacy programs, so that the acquiring contractor can profitably take aggressive steps to meet the customer's long-term requirements.

5. Award multi-year contracts, at least one per major contractor and at least three per service, to attract value investors, since multi-year contracts substantially increase stock valuations due to investor perception of controlled risk. The perceived decrease in risk will likely have a substantial impact on stock valuation. This will enable contractors to immediately raise necessary production capital by issuing stock or debt.

6. Move to a two-year appropriations cycle on research, development and procurement. This would help to stabilize programs, "lock in" savings to the Defense Department and create an environment of controlled risk to value investors. U.S. constitutional prohibitions against standing armies requires that military personnel, operations and maintenance funding must be appropriated on an annual basis. But Congress could readily move to a two-year appropriations cycle for research, development and procurement funding.

7. Encourage use of capital leases and operating leases for platforms. Bundled operations, maintenance and logistics con tracts would enable customers to leverage imminent shortfalls in procurement accounts. There is no legal prohibition against the Defense Department leasing assets, such as tactical airlift, naval logistics and auxiliary ships or transport trucks. However, capital leases (which are long term and have essentially all of the attributes of ownership) must be funded with procurement dollars, while shorter-term operating leases can be funded with operations and maintenance funding.

The Defense Department should focus on developing innovative leasing arrangements with responsive contractors, or even third-party leasing companies. Fiscal issues, contractual and personal injury/property liabilities must be addressed and bundled into a coherent package to generate long-term value for the customer.

8. Revise the cost principles in Federal Acquisition Regulations (FAR) Part 31 and other regulations to maximize the profitability of research and development work. This would make defense-unique work financially attractive to companies, even if they never get out-year production orders. Several "leap-ahead" technologies endorsed by the new administration are inherently high-risk and will only be "one off" systems, such as national missile defense, with no production or exports ever contemplated.

James McAleese is the principal of McAleese & Associates, in McLean, Va. His e-mail address is [e-mail].

Pentagon Contracts Lack Incentives for Research

Unrealistic cost estimates and schedules are damaging the Defense Department's ability to manage its weapon programs and to maintain a healthy industrial base, said the former chief of the Pentagon's testing office.

"Many contracts are structured with no incentive to continue to develop, to improve the system and every incentive to get into production as soon as possible. ... The contractual environment requires defense companies to make unrealistic bids simply to stay in the defense business," said Philip E. Coyle, who was the director of operational test and evaluation at the Defense Department from September 1994 until January 2001. "If you have tracked the stock prices of defense industry stocks, you can see that Wall Street has figured this out."

One way to turn these problems around, said Coyle in a recent interview, is to change acquisition practices that discourage contractors from focusing on early development and testing, because their main goal is to reach full-rate production as quickly as possible.

Since his departure from the government in January, Coyle has been trying to "get his message across" that the Pentagon may lose its ability to deploy cutting-edge technologies, unless it changes the way it compensates contractors.

"They need to permit a reasonable profit for development work," he asserted.

Defense contractors typically lose money in development contracts and only get to recover their losses if they get a large production contract. But, during the past decade or so, the Pentagon has cut back its procurement budget drastically, so production contracts are becoming more rare and smaller in the quantities of items ordered. That is a sure recipe for destroying the U.S industrial base, said Coyle. "We need to allow defense industry to make a reasonable profit in all phases of development, engineering, manufacturing and production," he said. The Defense Department "has put too much emphasis on making it up in production."

One way to protect the defense industrial base is to "maximize stability for defense companies," said Coyle. "There are several ways this might be done, and I don't believe they would take formal congressional approval in the form of new statutes."

One change that Coyle recommended is to return to the former practice of making development costs allowable expenses. Until about 12 years ago, up to 90 percent of development costs were cost-reimbursable under Pentagon contracts. Today, in many contracts, he said, "development is discouraged, leading companies to drive forward in production, despite unresolved development issues."

The Pentagon, additionally, should contract for research and development on a multi-year basis, Coyle said. Many defense R&D contracts are funded one year at a time. "This discourages higher risk, longer-horizon work in favor of 'quick hits' that can be realized in a year or so," he said. "If defense companies are not sure the Defense Department will ever fund a second, third or fifth year of research, they tend to minimize their own exposure if the R&D work is stopped."

Incentives for high-risk development work could be offered, by awarding higher percentage fees, depending on the level of risk, he said.

A revision of the Pentagon's acquisition rules, called the 5000 series, was issued last year. Among the changes was more emphasis on early testing, which Coyle supported. "The whole idea is to be able to get new military capabilities from the lab to the field as early as possible." But the regulations do not discourage the pursuit of rigorous testing, he said.

Defense programs benefit from early simulation and modeling work, which helps fix the kinks before the system goes to the field, Coyle said. "Too often, the program waits until they've gotten into trouble with cost and schedule and then they come to the testers and ask to cancel the test to save money and time. They want to do a simulation instead." At that point, he said, "it's almost always too late" to fix the problems. "Developing the simulations often is more difficult than building the system itself," said Coyle. "We've seen this with the [Air Force] F-22 simulator, which has been as difficult [to develop] as the F-22 avionics itself."

The Navy-Air Force joint trainer aircraft program, called JPATS, experienced problems, among other reasons, because it was treated as an "off-the shelf acquisition," even though the aircraft had military-unique requirements, said Coyle. "You really have to be careful about that." Commercial technology often "is not what people think it is," he said. "The military environment is just different."

The new leadership at the Defense Department needs to "make a new beginning" in acquisition reform, Coyle asserted. "They need to give it a different name." The bureaucracy can be cynical, he said. "That is why they need to take a new approach and a new name, so that it is clear there will be a new approach."

The nominee to replace Coyle as the top Pentagon tester is Thomas Christie. He heads the operational evaluation division of the Institute for Defense Analysis, a federally-funded think tank.

Coyle praised Christie's in-depth knowledge of operational testing issues. "He may know the business better than I do," he said.

Sandra I. Erwin