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U.S. defense industry in transition: can the leopard change its spots?

The 1990s are likely to see major transformations in the way that American business operates, but nowhere will the metamorphosis be more fundamental or widespread than in the U.S. defense industrial sector.

The overriding factor that necessitates a rapid conversion of the defense industry is the collapse, in 1989, of the former Soviet Union and Warsaw Pact. In a recent speech he made while still chairing the House Armed Services Committee, U.S. Secretary of Defense Les Aspin put the situation confronting the defense firms bluntly: "... even as we watch developments in the former Soviet Union, we should be preparing for a third revolution, a revolution in the way we go about the business of providing for our defense. It isn't really a matter of choice ... With old world defense budgets, we had to figure out how to apportion the increases. Now we have to figure out who gets the cuts - real cuts."[1] In fact, the defense budget has been reduced in real tenus every year since 1986, a trend that has accelerated since 1989.[2]

This most recent decline in defense procurement is the fourth since the end of World War U, but unlike earlier cycles, this time it is likely to be a permanent (lasting 10 to 20 years) reduction. And the collapse of the U.S.'s external enemies doesn't entirely explain the depth of the problem. Uncertainty about the future force structure and requirements has led Department of Defense (DOD) procurement organizations to limit new contract awards and to retain the funds for easing the transition of their own services. Even after contracts are awarded there are no guarantees that they will actually be funded, and if they are, they may be funded at a fraction of the original estimates.

If the past serves as a guide, there will be significant regional impact. In California, for example, job losses in excess of 200,000 people in the industry have occurred since 1989 and will continue for some time as the acquisition of new hardware is reduced to a minimum. Instead of producing Aff missiles and B-2s, DOD will fund less expensive paper studies, research and development efforts, and technology demonstrations. But these alone cannot support the defense production capacity found in regions like Southern California.

The result for most companies is clear - they must either greatly reduce their dependence on DOD contracts through diversification and conversion or face the future with a shrinking business base and possible extinction.

What is conversion/diversification?

The popular conception equates "conversion" or "diversification" with rebuilding specific facilities currently used for defense production, with a goal of producing commercial products at that facility, using the same workers who had previously worked at the defense facility. This could be termed plant level conversion. This is a restrictive definition, and from the perspective of the industry, an unrealistic one.

The govermnent's desire to see direct plant level conversion arises from an interest in reconstitution. From the national security perspective, reconstitution is a vital consideration any conversion effort.[3] Ideally, conversion should be done in such a way that would allow a rapid return to defense production should the need arise. In practice it would mean that defense industry firms would not strive to convert for maximum efficiency (which will almost certainly be irreversible), but should try to compete in the commercial world with a less-than-optimally-efficient plant and facility.(4) But without a direct government policy that would provide funds for maintaining a reconstitution capability, it is unlikely that the companies can afford to take half-measures in the conversion process.

Because of the difficulties outlined above, when conversion is discussed within the industry the emphasis is on other strategies that fall into a broader meaning of the words. These other strategies can be named corporate level conversion because they focus on efforts to change the nature of the entire corporation, as opposed to rebuilding specific plants and facilities.

Corporate Strategies

In general terms, the options for the firms fall into five categories, aspects of which companies may combine into a number of variants. These approaches are: simple downsizing of the company to match lower demand, reallocation of resources from defense production to existing commercial production, diversification within DOD by pursuing new, non traditional products and customers, diversification within the government by pursuing new products and customers outside DOD, and diversification into commercial markets through acquisitions, mergers, start-ups and joint-ventures.

A number of the firms in the industry have publicly adopted one or more of these business strategies. General Dynamics CEO William Anders has opted for the simple downsizing approach, concentrating the company more on defense. The rationale expressed by Mr. Anders is a "core competency" argument - defense is what the firm knows and does best, and it is best to stick to it.[5] Boeing and McDonnell Douglas have adopted a reallocation of resources strategy, hoping to offset declining sales to DOD by increasing sales of their commercial aircraft. others, like GM-Hughes, are trying to increase sales to other agencies of the U.S. government, such as the Federal Aviation Administration and Department of Transportation. And, of course, all of the firms are trying to increase foreign sales of military goods, such as General Dynamic's plan to sell F-16s to the Republic of China, and McDonnell Douglas' announced sale of F-15s to Saudi Arabia.

Conversion to

Commercial Production

The adoption by defense industry firms of a strategy of entering commercial markets through acquisitions, mergers, start-ups and joint-ventures is, perhaps surprisingly, the most controversial. Although it seems that this would be the most desirable outcome, objections are raised concerning two issues: first, it is rare that a plant level conversion can be undertaken, resulting in plant closures and job losses in the local economy; second, there are many sceptics who suggest that defense industry firms have an uncommonly poor record in converting to commercial markets.[6]

The first objection, that corporate conversion rarely takes advantage of the existing industrial base of the company, is often true. Making the decision to abandon a business area, to close facilities, and lay off employees is difficult, distasteful, and agonizing. But this situation is not unique to the defense industry: it is what economist Joseph Schumpeter called "creative destruction."

The second issue, the perceived inability of defense firms to convert is based upon anecdotal evidence and on several studies done in the mid-to late - 1980s. But upon examination, the thesis doesn't seem to hold up. The data in Michael Porter's study of 33 U.S. companies'[7] (both defense and non-defense) acquisitions and later divestment of businesses showed no particular pattern, and indeed, defense companies were among those at both extremes of the sample. Moreover, a more recent survey done by DRI/Fraser Group/Winbridge Group reveals widespread plans among defense industry companies to enter commercial markets and satisfaction with the success of efforts already underway.(8)

In fact, there are many reasons to believe that the factors that determine the success or failure of defense industry conversion efforts are the same ones that affect other industrial sectors: the underlying financial health of the parent organization, the degree to which management understands the product and the market, and so on.

Two Conversion Successes

Two large defense firms, Rockwell International and United Technologies (UT), provide case studies for making the transition from a primarily defense firm to a primarily non defense firm.(9)

In the middle 1960s, North American Rockwell and UT were dependent on sales to DOD.(10) In 1989, the situation was reversed, with the firms receiving between 25 and 35 percent of their sales from DOD and the remainder from commercial and non-DOD government sources. Both used a similar strategy, with many common characteristics, during the process.

The cornerstone of the strategy of these companies was to use mergers and acquisitions to gain a fairly rapid foothold into commercial markets. Rockwell International itself was formed as the result of mergers between North American Aviation and Rockwell Standard (1967) and a second merger with Rockwell Manufacturing Company (1972). Over the years, numerous acquisitions of companies in commercial markets have been made. Rockwell acquired Admiral Appliances in the 1970s (a disaster) and Allen-Bradley (a great success) in the 1980s. Rockwell has been in businesses as diverse as textiles and luxury yachts, although most of its acquisitions have been in the automotive sector and high-technology electronics. One rather unusual, but significant, component in the corporate mix is Rockwell/Goss, a manufacturer of highspeed color printing presses for newspapers, considered to be the industry leader in the world today.

UT, similarly, is a product of numerous mergers and acquisitions that occured especially during the period when Harry Grey was CEO of the company. During his tenure, UT acquired Otis Elevators, Carrier Air-conditioning, and Mostek, the pioneer semiconductor manufacturer. In 1982, UT acquired two telecommunications groups from General Dynamics.

Both companies have systematically reduced the amount of fixed assets (plants and equipment) in their defense businesses. They have used their defense business as a "cash cow" to support the development of their non defense ventures. When possible, they have used defense technologies to provide a technical edge in their non defense markets, and they have been most successful when supplying intermediate users, rather than retail markets. It is interesting to note that both Rockwell and UT had a significant international market presence, unlike most American companies, long before Europe '92 or the opening of Central and Eastern Europe became a recognized phenomena.

Finally, perhaps the most important single factor: management persistence. A review of the annual reports for these companies over a 20-year period reveals a consistent, long-term goal of reducing dependency on DOD sales during periods of defense spending growth as well as decline.

Corporate Considerations

It is somewhat paradoxical that, although it is much easier for a financially healthy company to transform itself, defense companies wait until they are in great financial difficulty before seriously considering conversion/diversification. The situation at the end of the 1980s was no exception. The quip, "You can make a small fortune in the defense business - provided you start out with a large one," (11) was unfortunately apropos.

During the latter 1980s, the financial condition of defense industry firms deteriorated significantly. According to an article in Aviation Week & Space Technology, defense stock prices declined by 40 percent during that period, forcing the firms in the industry to substitute debt for equity, with debt levels growing by 81 percent.[12] Many of the companies were reaching their borrowing limits, paying high interest rates (relative to other industries), and their debt ratings were lowered. Earnings declined by 45 percent while the assets/sales ratio grew four-fold. Return on sales (ROS) dropped by 50 percent, return on investment (ROI) dropped to about half of the prevailing industry cost of capital. Investment in inventories and receivables doubled, reducing available funding for other, profitable activities.[13] Several of the largest U.S. defense contractors had debt-to-equity ratios of 70 percent or higher![14]

Since then a number of the firms - notably General Dynamics, McDonnell Douglas, and Northrop - have significantly improved their balance sheets through sales of assets and closing down unprofitable divisions and projects. Whether this will give them the breathing room for conversion remains to be seen.

In addition to the financial fragility of many of the defense firms there is the problem of changing the management culture and style within the organization. This may be more difficult to solve than the short-term financial situation.

Economist Ludwig von Mises once wrote that economic organizations are organized on one of two models, a market-driven model or a bureaucratic (i.e., rule-based, centrally-controlled) model.[15] The defense companies, although they must survive in the free-market economy, have come more and more to resemble their customer in this regard, becoming something of a hybrid - a bureaucracy that must turn a profit.

Weaning top managers away from the comfort of supplying DOD and into risky, commercial markets is difficult. Many industry managers still deny that a problem exists, suggesting that as the pie shrinks, their company will simply gain a larger share of the pie. Even those who understand the magnitude of the problem have been slow to respond and take positive steps to open new product areas and markets.

A number of factors appear to be at work here.

Most top executives in the defense industry have spent their entire careers in the industry and, consequently, have no other conceptual model to follow. Given the alternatives of "investing" money in a proposal to DOD for a multi-year, multi-million dollar contract, or a similar amount into a venture that might not break even in less than three-to-five years, most will pursue the DOD contract. And the large number of former military officers who have joined the defense firms in business development and strategic planning positions has re-enforced this tendency. After a career in the government, it is a rare individual who can suddenly change perspective from the bureaucratic to the entrepreneurial. neurial.

Conversion requires managers who are willing to rock the boat in an environment that generally encourages conformity. A senior engineer involved in the conversion effort at his company la division of a major industry firm) remarked that many of the most valuable employees in the conversion process are employees who were once considered "boatrockers" and "mavericks." But, as another industry observer has written, "... employees who are terminated in the early stages of a downsizing are often the round pegs in square holes - the ones who don't quite fit into the corporate structure, but may be a likely source of alternative (read: entrepreneurial) ideas."[16]

The Role of Government

The government also has a stake in seeing successful conversion of the firms in the defense industry. The policy issues are clear: maintaining the "best" military capability within the budget constraints while encouraging the growth of new jobs to replace those lost, ensuring that technologies developed in the defense sector are disseminated into the private sector economy, and minimizing other national and regional impacts.

One positive change that would benefit the firms, the economy and the government would be to greatly reduce the regulatory burden on the industry. At a recent conference, Murray Weidenbaum, former Chairman of the President's Council of Economic Advisors, suggested that the current procurement regulations - a massive 16,000 pages - should be thrown out and replaced by "100 pages" of guidelines.[17] Such a reduction in transaction costs would make the remaining defense production more efficient for the government and also help the industry financially. It would facilitate the dual use of plant and equipment that are segregated today because of the onerous burden that government regulations de facto impose on any commercial production taking place in a facility engaged in DOD production.

A second, potentially fruitful area in which the government could assist the industry is in technology transfer. Reducing the legal barriers restricting firms' abilities to use technologies originally developed under government contracts would make it more attractive to develop commercial products from them. There are many technologies developed in government laboratories that could be useful in the private sector, as well. Currently, accessing them is difficult because the system for acquiring information and rights to them differs from one lab to the next. A uniform system for making technologies available, possibly modeled on a system of regional offices that serve as clearinghouses for such information (as NASA has established), could provide an outlet for these technologies.

Finally, the government, including Congress, the president, and the DOD, could try to limit rapid gyrations of funding and direction. No company can adjust to instantaneous market changes, especially those of the magnitude that have characterized DOD procurement over the last two to three years. The defense budget has become a grab-bag for too many congressional pet projects and, laudable as many of these projects may be, it creates unnecessary difficulties that could be mitigated by a small amount of restraint. The process will be difficult enough; it should not be made harder.

The Outlook for Conversion

One factor that should make conversion easier this time is that the magnitude of the problem is smaller. According to former DOD industrial specialist John Lynch, the size of the defense industrial sector had already declined from 6.3 percent of GNP in 1986-87 to 5 percent of GNP in 1991.(18) By comparison, defense represented 13.2 percent of GNP at the end of the Korean War and 8.8 percent of GNP in 1968, so this current decline should be easier for the non-defense economy to absorb.[19]

If the collapse of the Soviet Union and Warsaw Pact has caused sales to the U.S. government to shrink, there is another side to the equation: a world of new markets. The former Soviet Bloc must rebuild its entire industrial infrastructure. Southeast Asia and Latin America have been opening their markets to U.S. firms and are now eager and financially able to buy U.S. goods.

As a consequence, defense manufacturers have a surprisingly strong market to enter, one that can benefit from the characteristics of the industry - high-technology capital goods. According to joint research by Andrew Warner of Harvard and the Washington Federal Reserve Bank, there is a U.S. advantage in this sector, and it is the growth of this sector that has been fueling the recent export boom.(20) These goods take advantage of the very areas in which defense industry firms excel: advanced manufacturing, low unit production rates, high cost-per-unit, system complexity, and computer/control-intensive systems.

Given the renewed demand that the domestic infrastructure be rebuilt, the U.S. itself may prove an interesting and expanding market for ex-defense firms as well. Highways will be superseded by "Intelligent Vehicle Highway Systems." Water and sewer systems, bridges, and buildings all need real-time feedback and control systems - which defense firms can provide.

Several creative ideas for assisting the industry firms were presented during testimony to the President's Commission on Defense Industrial Conversion in August 1992. Robert Schlesinger, of San Diego State University, has suggested an "intrapreneurial" approach. His proposal is to have the firm identify programs that are to be shut down and invite a small team of outside entrepreneurs to assist the affected employees for a period of 120 days, during which time the employees would remain on the payroll. A detailed business plan would be created, and a new corporation formed. The contractor would assign the critical physical and intellectual capital to the new corporation and would, in exchange, receive equity in the new corporation. A period of time would be agreed upon for the new corporation to establish itself. if the venture didn't work out, the assets would revert to the parent company. If it were successful, then new jobs would have been created, technology would have been transferred into the commercial sector, the defense firm would own part of a growing concern-everyone would win.(21)

We may have entered a new phase, as former Council of Economic Advisors economist Myron Ross suggests; the beginning of a new Schumpeterian wave of "creative destruction," in which the old industrial structure is swept away by a new, "smart" industrial revolution. And that revolution can be fueled by defense industry companies if they will seize the vision and transform themselves to take advantage of it.

[1] U.S. Representative Les Aspin, "Tomorrow's Defense From Today's Industrial Base: Finding the Right Resource Strategy For a New Era," speech to the American Defense Preparedness Association, February 12, 1992. [2] Data taken from testimony of the Comptroller of Defense, "Comptroller Briefing Charts, FY 1993 Budget," before the Senate Armed Services Comittee, January 29, 1992. [3] This very point has been raised recently by Kenneth Adelman and Norman Augustine in an article, "Defense Conversion" for Foreign Affairs, Spring 1992, 26-47. (4) Analysts have suggested the flexible factory as a means of rapidly going back and forth between defense and commercial production. It is not so facile in practice. it might be possible in a few selected areas like electronic components, but that will be the exception, not the rule. [5] William Anders, in a keynote address, "Rationalizing America's defense Industry," to the 12th annual Defense Week conference, October 30, 1991. [6] Anders, Ibid, 13. Murray Weidenbaum made a similar point in a paper presented to the annual meeting of the Western Economic Association, "The Future of the U.S. Defense Industry," July 1, 1991, 2. [7] David Hughes, "Survey on Defense Firm Commercial Efforts Shows Surprising Success Rate Activity," Aviation Week & Space Technology, December 9, 1991, 21-22. (8) The data for this section were taken from annual reports over the period 1968-1989, analyses performed by firms such as A.G. Edwards, and other documents and magazine articles. (9) In 1968, North American Rockwell made 47 percent of its sales to DOD and 28 percent of its sales to NASA which was also undergoing major reductions because of the end of the Apollo program. Before the 1967 merger with Rockwell Standard, North American Aviation did almost 80 percent of its business with DOD. (10) John T. Correll and Coleen A. Nash, "Declining, Diversifying and Disappearing," Air Force Magazine, October 1991, 38. (11) In the 1980s the trend of increasing debt-to equity-ratios was pervasive throughout U.S. business. According to a study by Frederick Furlong, "Tax Incentives for Corporate Leverage in the 1980s," published in the Economic Review of the Federal Reserve Bank of San Francisco, Fall 1990, Number 4, the book-value debt-to-equity ratio for non financial firms had risen to slightly above 50 percent in 1989. The 81 percent average of the defense industry firms is still significantly higher. [12] Anthony Velocci, Jr., "U.S. Defense industry Must Change Ways to Stay Out of Financial Emergency Room," Aviation Week & Space Technology, December 24, 1990, 16-17. [13] Ira E. Cornelius and Richard H. Young, "Macro Competitor Assessments - Major Aerospace Prime Contractors," Rockwell international, Seal Beach, September 1990. This study drew upon a number of sources, including Defense News, Space News, Aviation Week & Space Technology, Value-Line, and others. [14] Ludwig von Mises, Bureaucracy, Cedar Falls: Liberty Press, 1944, reprint 1983. Preface to the 1962 edition, 1, 24-26. This description is not intended in a denigrating fashion, which is sometimes associated with the term "bureaucratic" or "bureaucrat;" its use here is to describe a style of organization, which is often the appropriate solution for providing government services, e.g., the military. [15] Robert J. Schlesinger, "For Entrepreneurial Conversion," San Diego Daily Transcript, July 28, 1992, Opinion and Comment. [16] Ethan B. Kapstein, Reconstitution: Force Structure and Industrial Strategy, conference report, Strategic Studies Institute Special Report, U.S. Army War College, June 1992, 2. [17] John Lynch, in a presentation during the "Defense Industry Downsizing: A Comparative Perspective," February 5, 1991, Harvard University, Cambridge, MA. (18) John Lynch, loc cit. [19] Lawrence Lindsey, "America's Growing Economic Lead," Wall Street Journal, February 7, 1992, A, editorial page. Also, Karen House, Japan's Decine, America's Rise," Wall Street Journal, April 21, 1992, A, 18. U.S. exports increased 13 percent yearly from 1986 to 1990. Capital equipment exports from the U.S. have risen from 30 percent (of a smaller base) in the late 1960s to 41 percent of exports today. (20) Schlesinger, loc. cit.

Richard T. Minnich has been a defense policy and economic analyst in the areospace industry since earning his Master of Business Administration degree from California State University, Los Angeles in 1983. He recently contributed a chapter on the micro-economic aspects of defense industry conversion for a forthcoming book to be published by the John M. Olin Institute for Strategic Studies at Harvard University. The data and research were incorporated into this article.
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Author:Minnich, Richard T.
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Date:Jan 1, 1993
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