THE FUTURE OF THE U.S. DEFENSE INDUSTRY

THE FUTURE OF THE US. DEFENSE INDUSTRY MURRAY WEIDENBAUM*

Defense contractors in the United States face a painfirl choice between downsizing or investing in new high-risk commercial ventures. Past experience reveals numerous failed eforts to penetrate commercial markets and fm, if any, successes.

The capabilities required to succeed in civilian business are fundamentally diferent @m those needed to design and produce weapon systems. Defense j i r m s and defense divisions of divers$ed corporations lack adequate knowledge of commercial products, production methods, advertising and distribution, financial approaches, and customer demand.

Given the outlook for a sustained decline in U.S. militay spending, the author advises companies catering to military markets to cut their costs by reducing excess capacity. Smaller but more competitive positions can be achimed through restructuring, mergers, sales of assets, and, if necessa ry, closing down unneeded facilities. Firms that ignore the pleas for ”conversion” and do not dissipate their assets in civilian markets alien to them stand the best chance of surviving during a period of reduced milifay demand.

1. INTRODUCTION

The prospect of substantial declines in defense spending has forced the U.S. defense industry to rethink long-term pros- pects. Should the defense contractor convert to civilian production, and thus ob- tain a civilian payoff on the massive national investment in defense technology, or take the tough-minded approach of cutting back from its current level of defense production?

Conversion has a great deal of popular appeal because it claims the benefit of keeping in place the existing jobs of defense workers who otherwise might face extended unemployment. The cutback al-

‘Murray Weidenbaum is Mallinckrodt Distin- guished University Professor and Director of the Cen- ter for the Study of American Business at Washington University in St. Louis. This is a revised version of a paper presented at the Western Economic Association International 66th Annual Conference, Seattle, Wash., in a session organized by the author. The paper draws on the author’s book, Small Wars, Big Defense, Oxford University Press, 1992.

Contemporary Policy Issues Vol. X, April 1992

ternative, in contrast, is designed to maintain the financial health of the firm through reducing excess capacity of labor and facilities.

This article develops several key con- clusions to guide the defense firm’s selec- tion between these two polar alternatives. A substantial downsizing is the most sensible response to the greatly reduced market for military equipment that is likely in the 1990s. The major U.S. defense firms will be much smaller and fewer in number than they are today. Those that husband their resources and avoid investments in civilian diversification beyond their basic capabilities will stand a better chance of survival.

II. VARIATION IN CONVERSION EXPERIENCES

Since the end of World War 11, the major defense contractors have been trying to use their special talents in other areas of the economy. They have been extremely successful in converting-or, to use the preferred business term, diversifying-

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@Western Economic Association International

28 CONTEMPORARY POLICY ISSUES

into several large but closely related market areas.

The expansion from aircraft to missiles and space vehicles, for example, was a natural and noteworthy progression. Be- cause it happened without much economic disruption, few appreciate the tremendous transformation of the airframe manufacturers into aerospace designers and producers. Over the years, several large aerospace companies (General Dy- namics, Lockheed, and McDonnell-Doug- las) also have developed and manufac- tured substantial numbers of civilian pas- senger aircraft. Except for Boeing, profitability has been elusive, and McDonnell- Douglas remains the only other US. com- pe ti tor.

The numerous attempts on the part of the larger, specialized defense contractors to penetrate civilian non-aerospace markets have not met with similar success, however. The failed products range from canoes to computers to coffins (see Denver Research Institute, 1966; Lynch, 1987).

Most of the diversification ventures outside of the defense and aerospace markets have been abandoned or sold off. The remainder generally operate at marginal levels. These negative experiences have been so frequent and so financially drain- ing that they now constitute a major ob- stacle to further commercial diversification.

A recent survey of defense firms by the Center for Strategic and International Studies (CSIS) confirms these negative findings. A majority of the companies re- ported that they believe a reorientation to civilian production is ”neither feasible nor desirable.” Most of the others are focusing on non-military opportunities in government (Reddy, 1991, pp. 5-6).

Curtiss-Wright provides the most ex- treme example of the shortcomings of the naive diversification approach. This pion- eering aviation firm, which built more aircraft during World War I1 than any other U.S. company, acted on the assumption

that the military market would never re- cover from its post-World War I1 lows. It diversified with a vengeance into a host of miscellaneous industrial product areas. Curtiss-Wright never recaptured its previous highs. While its former competitors now enjoy annual sales of aircraft, missiles, and space vehicles in billions, Curtiss- Wright’s total revenues from its assortment of parts and components total a modest $200 million a year.

111. WHY DIVERSIFICATION FAILED

Studying the diversification experiences of military contractors reveals com- mon trouble spots. Although these specialized business organizations are very good at designing and producing state-of-the- art weapons, they must differ from typical commercial companies in order to do their job well. For example, defense firms have low capitalization, little commercial marketing capability, and limited experience in producing at high volume and low unit cost. Moreover, they must gear their ad- ministrative structure to the unique re- porting and control requirements of their one customer, the government. Defense firms that do operate in civilian markets usually maintain operationally separated, insulated divisions that report to the same top management, but have little contact with each other (Dumas, 1984, p. 69).

In a study for the President’s Economic Adjustment Committee, the Battelle Me- morial Institute explained that defense plants have been designed with a single product line or production process in mind in order to be cost-effective. ”There- fore, by their very nature, [these] production facilities do not easily lend them- selves to reuse” (Battelle Memorial Insti- tute, 1985, p. N-7).

In the CSIS survey cited earlier, 71 percent of the defense firms stated that the Pentagon’s procurement policies make it difficult for them to enter or to flourish in civilian markets. Bolstering their data with in-depth interviews, the researchers con-

29 WEIDENBAUM: THE FUTURE OF THE U.S. DEFENSE INDUSTRY

cluded that the Department of Defense (DOD) acquisition system is a major ob- stacle to civilian diversification, and that military production has evolved into a business culture distinct and closed off from the normal commercial environment. The lack of commercial marketing experience is another concern familiar in defense industry circles. Grumman developed and tried to sell a mini-van years before Chrysler popularized the concept, but failed because of an inadequate distribution system.

One defense industry representative offered a typical summary of these prob- lems: ”With this high overhead, together with the facilities, manpower, and systems oriented toward [defense] work, it is extremely difficult to find civilian markets where we can be cost-competitive” (Reddy, 1991, p. 27). Not surprisingly, defense company managements have be- come reluctant to move from fields they have mastered into lines of business alien to them. Almost universally, they lack knowledge of nondefense industry products, production methods, advertising and distribution techniques, financial arrange- ments, contracting forms, and customer demands. A company that successfully designs and builds a multibillion dollar ICBM network or space exploration system has very different capabilities than the cost-conscious, low-technology soap, steel, or toy company competing in the commercial economy. The chief executive of Martin-Marietta, a large and successful defense contractor, underscored this point recently when responding to the Soviets’ request for advice about how to convert a tank-producing facility into a refrigerator factory. He recommended tearing down the tank plant and building a new factory (Augustine, 1990, p. 22).

IV. THE FUTURE OF THE MILITARY MARKET

The military market is not about to disappear, but a period of severe belt tightening has arrived. Most likely, the

overall voiume of defense business will decline substantially in the early 1990s, albeit defense spending will remain high by historical standards. Such fluctuations in business opportunities are not unique to defense companies.

Other sectors of the economy regularly adjust to market shifts as part of the normal workings of a private enterprise system. Similarly, the military market has been cyclical in nature. However, it has experienced a very different cycle than most commercial businesses. U.S. defense spending over the past half century has followed a stop-and-go (or, rather, a go- and-stop) pattern.

A. Historical Perspective Since the beginning of World War 11, the

military budget has never experienced an extended period of stability. Eras of rapid growth have alternated with times of aus- terity. Often, changes in the size and direction of military spending have mirrored shifts in the national security environment. This was the case when the end of hostilities after the Vietnam War permitted a substantial reduction in military spending. At other times, the shifting internal response to a relatively constant set of external factors has been more subjective. Witness the rapid buildup in the early 1980s and the abrupt decline starting in the middle of the decade. That sudden change occurred during a period when the threat to U.S. national security remained relatively constant.

B. Future Outlook Optimistically, the minimum change

following the end of the Persian Gulf conflict will be a resumption of the previous mild downtrend in the military budget. As in the late 1980s, the military budget over the five-year period 1991- 1995 will rise in nominal terms, but not rapidly enough to offset the effects of inflation. In this scenario, defense spend-


ing declines at a rate of 2 percent a year after allowing for inflation, and generates an approximately $80 billion reduction compared to a stable real level of defense outlays (U.S. Congressional Budget Office, 1990a, p. 66).

In a more probable scenario, Congress refrains from voting to increase the military budget even nominally. If the United States continues to experience an average inflation rate of about 4 percent a year, the budget declines at the 4 percent rate, after inflation. This approach generates a $158 billion reduction in defense outlays over 1991-1995 compared to a stable level (see table 1).

Prior to the invasion of Kuwait, some military experts offered a third, more pes- simistic scenario-cuts in the defense budget by as much as one-half over the com- ing five years (Evans, 1989, p. 1; Korb, 1989, p. 23; ”Sen. Nunn on Vision of Mil- itary,” 1990, p. A10). In light of recent developments, however, reductions of this magnitude might well be accompanied by some offsetting increases to procure weapon systems such as those used against Iraq.

V. DEFENSE COMPANY RESPONSES

The same basic outlook emerges under each scenario described above: the size of the domestic market available to U.S. defense contractors will steadily erode. What impacts will these firms experience as a result, and how are they likely to respond?

A. ?lie Major Defense Prime Contractors Because the major defense contractors

vary in their dependence on the military market, they react in different ways to major changes in military spending (see table 2). Let us focus initially on the large aerospace companies that rely on the De- partment of Defense for most of their income, firms such as General Dynamics, Grumman, Lockheed, Martin-Marietta, and McDonnell Douglas.

Some, such as General Dynamics, di- versify widely within the military market, producing aircraft, missiles, tanks, and submarines. Others, such as Martin-Mari- etta, have gained fairly secure niches within specific product areas. Some companies achieve an advantage by winning major weapon-system competitions, as Lockheed did recently in the case of the advanced tactical fighter. Still others, such as McDonnell Douglas, have diversified to a significant degree into commercial aircraft work, albeit without attaining significant profitability.

Contractors such as Grumman and Northrop are likely to be in for a difficult time if the few weapon-system contracts upon which they depend are jeopardized. More vulnerable than diversified defense contractors, they are responding accord- ingly. Northrop reduced its research and development (R&D) effort 46 percent in real terms between 1985 and 1989, while Grumman’s company-initiated R&D, after adjustment for inflation, slipped by 78 percent during that period. Servicing their high-debt loads limits these companies’ ability to invest in new undertakings, be they civilian diversification efforts or defense projects.

Because the military depends greatly on the prime defense contractors for designing and building key weapon systems, their survival as a group is assured. Nevertheless, substantial excess capacity coupled with weak finances render indi- vidual companies extremely vulnerable. Even if all are able to weather the storm, they will not retain their current volumes of sales and employment.

B. Major Defense Divisions of Civilian-Oriented Companies A second set of major defense contrac-

tors-including Boeing, General Motors, Honeywell, Rockwell, Tenneco, Texas In- struments, Textron, and TRW-look to commercial markets for most of their busi-

WEIDENBAUM: THE FUTURE OF THE U.S. DEFENSE INDUSTRY 31

TABLE 1 Savings from Alternative Defense Paths

Compared with the CBO Baseline (fiscal years, in billions)

Total Category of Spending 1991 1992 1993 1994 1995 1991-1995

2 Percent Annual Real Decline in Budget Authority

Change in Defense Spending $-4 $9 $-15 $-22 $-30 $40

Change in Interest Spending a -1 -2 -3 -5 -11

Total Change in Deficit $-4 $-lo $-17 $-25 $-35 $-91

4 Percent Annual Real Decline in Budget Authority

Change in Defense Spending $4 $-18 $-30 $-44 $-58 $-158

Change in Interest Spending a -1 -3 -6 -10 -20

Total Change in Deficit $4 $-19 $-33 $-50 $ 4 8 $-178

a = Less than $500 million. Source: Compiled from Congressional Budget Office data.

ness. These companies will benefit from the expansion of civilian markets, especially if macroeconomic policy succeeds in maintaining high levels of economic activ- ity. Because their contracts with the Pen- tagon generally are less profitable than their commercial sales, some will respond to shrinking military markets by phasing down their defense business or trying to sell their defense segments. For example, AT&T’s highly regarded Bell Laboratories left the market after a previous military cutback.

C . Subcontractors and Suppliers A large array of small businesses are

prime contractors or subcontractors and suppliers to the large defense firms. Some will be badly hurt in the defense transi- tion, especially as the large prime contractors pull business back into their own factories. However, many smaller firms are more capable of dual military and

commercial work than are the larger, “muscle-bound” prime contractors. Oth- ers may follow the lead of subcontractors who abandoned the military market during the buildup of the 1980s in favor of less regulated commercial work, which is more profitable on average (Blackwell, 1989).

VI. STRATEGIES FOR DEFENSE CONTRACTORS

Policy advisers who choose the politi- cally popular alternative will tell defense contractors to convert their operations to other pursuits despite the historical evi- dence, especially in the case of the larger firms. Seasoned defense industry execu- tives show a more chastened and in- formed view. Stanley Pace, recently retired chief executive of General Dynamics, says, “We‘ve all come from smaller companies. We can all go back to being smaller companies” (Wayne, 1989, p. 14’). Malcolm Currie, chairman of Hughes Aircraft,


TABLE 2 Defense Dependency of the 25 Major Contractors, 1989

Rank Company Percent

75-1001 of Sales to Military

6 Lockheed 2 General Dynamics 8 Martin Marietta

50-74% of Sales to Military

10 Grumman 24 Avondale Industries 1 McDonnell Douglas 4 Raytheon 7 United Technologies

15 Litton Industries

25-49 % of Sales to Milita ry

17 TRW 20 Texas Instruments 12 Rockwell International 13 Westinghouse 22 Textron 25 FMC

91 % 87 75

70 70 60 55 50 50

40 33 25 25 25 25

0-24% of Sales to Military

9 Boeing 20 18 Unisys 20 23 Allied Signal 20 3 General Electric 16

21 Tenneco 15 14 Honeywell 13 11 GTE 10 19 ITT 8 16 IBM 5 5 General Motors 4

Source: Center for the Study of American Business, from various sources.

voices similar sentiments: ”The defense industry does not have to be at its present peak size to be a very healthy, profitable, vital industry” (Pasztor and Wartzman, 1990, p. A8).

Clearly, a substantial downsizing is the most sensible response to the greatly reduced market for military equipment that is likely in the 1990s. The sooner the major

contractors reduce their excess capacity through restructuring, mergers, sales of assets, or simply closing down unneeded facilities, the greater will be their ability to withstand the competitive rigors of the new military marketplace.

This prescription is not as radical as it may seem at first. Many mergers have occurred in the defense industry over the

WEIDENBAUM: THE FUTURE OF THE U.S. DEFENSE INDUSTRY 33

years. McDonnell Aircraft acquired Doug- las Aircraft. Electric Boat merged with Consolidated Aviation to form General Dynamics Corporation. Rockwell Interna- tional is the consolidation of North Amer- ican Aviation and Rockwell Standard. Boe- ing acquired Vertol Aircraft. United Tech- nologies combined United Aircraft and a variety of civilian companies such as Car- rier and Otis Elevator.

The shape of things to come in the U.S. defense industry can be seen across the Atlantic. Consolidation is a clear trend in Western Europe. In recent years, Germany’s Daimler-Benz acquired Mes- serschmitt-Bolkow-Blohm, and a combi- nation of Germany’s Siemens and the United Kingdom’s General Electric Com- pany took over Britain’s Plessey.

During the next five years, the market for weapon systems is likely to decline by one-fourth or more (U.S. Congressional Budget Office, 1990b). As a result, the U.S. defense industry will look significantly different by the mid-1990s than it does today. The major firms will lose the peak size they attained in the 1980s, and their overall number may decrease. However, by avoiding fruitless conversion attempts and by streamlining their operations, they can achieve that new condition with few bankruptcies or hostile takeovers, and with reasonable levels of profits and jobs.

Lockheed‘s decision in 1990 to close down all its aircraft production at Bur- bank, the city where it was founded, illus- trates the future of the defense industry. In similar actions, Honeywell spun off its torpedo and munitions business to its shareholders after trying unsuccessfully to sell it to other companies, and Emerson Electric and Unisys spun off their defense divisions as well. Varian Associates dropped most of its defense operations to focus on more profitable lines of electronic equipment.

No great unmet needs exist in the slow- growing American economy, and commercial needs that do arise will no doubt be

served by civilian-oriented companies highly experienced in those markets. However, defense contractors can be expected to continue searching for new applications of their existing product lines, especially in closely related markets. Grumman is working on a $1 billion contract with the U.S. Postal Service to build approximately 100,000 delivery trucks. Boeing has sold some of its Vertol helicopters to oil companies to service offshore drilling platforms. Martin-Marietta has won a $900 million contract from the Fed- eral Aviation Administration to help over- haul the nation’s air traffic control system. The Sikorsky Division of United Technol- ogies has produced over $200 million of helicopters to aid the Coast Guard in in- tercepting drug smugglers, and Lockheed sold two radar planes to the Customs Service for $58 million. The list goes on. But, in the aggregate, these close civilian applications of military products are a minor fraction of the military market. The $1 billion spent annually for drug interdic- tion equipment is dwarfed by the $120 billion allocated each year to the development and acquisition of weapon systems. Moreover, in time these new diversification efforts may prove to be no more financially successful than past attempts.

VII. CONTRASTING APPROACHES

Military contractors can choose between two very different models of corpo- rate behavior in responding to large cutbacks in the defense budget. To sim- plify, let us call these the Boeing and the Grumman approaches.

When faced with a very large decline in the orders for its aerospace product line in 1971, Boeing reduced the size of the company substantially, laying off over one- half of the entire work force. One wag rented a billboard for a memorable mes- sage-“The last one out of Seattle, please turn off the lights.”

Boeing‘s cutbacks were radical, extend- ing to experienced engineers and crafts-


men with considerable seniority. How- ever, the downsizing left the company financially strong enough to rebound. Boeing is now a world-class corporation leading the current upturn in commercial aircraft sales and production with a record backlog of approximately $100 billion in orders as of late 1991.

In contrast, Grumman followed the advice of conversion advocates, investing heavily in non-aerospace diversification. The result has been unsuccessful, and Grumman has weakened financially. Moreover, the job-creation objective that motivated the conversion approach was not achieved. In June 1990, the company offered early retirement to more than one- fifth of its work force.

Defense contractors cannot be expected to behave as eleemosynary institutions. The Boeing approach of course hurt the people laid off, their families, and their communities. But the ability to effect such initially drastic, yet ultimately healing, change separates a dynamic private-enterprise economy from the static, centrally planned societies which have failed so dramatically in recent years.

Ironically, the strongest support for maintaining the current size of the defense companies by converting them to civilian markets comes from those who had most vehemently attacked their "wasteful cost- plus" mode of operation (see Melman, 1970). Surprisingly, these critics do not welcome the rare opportunity to move resources out of those companies to what they consider to be more efficiency- minded, civilian-oriented enterprises.

VIII. CONCLUSION

The Persian Gulf crisis amply demon- strated that the United States still needs a powerful military establishment and a strong base of defense contractors but not the present size. Change is an essential aspect of a modem competitive economy. In the 1980s, the tremendous expansion of

aerospace and other defense companies attracted people and capital from other parts of the economy, often to the discom- fort and displeasure of commercial companies. We should not expect that type of movement always to be in one direction.

REFERENCES

Augustine, N. R., "The Real Dividend Is Peace," World Link, May-June 1990, 22.

Battelle Memorial Institute, "Feasibility of Prompt Im- plementation of New Technologies by Civilian In- dustries to Offset Defense Contractor Cutbacks," in Economic Adjustment/Conversion: Appendices, President's Economic Adjustment Committee, Washington, D.C., 1985.

Blackwell, J., Deterrence in Decay: The Future of the De- fense Industrial Base, Center for Strategic and In- ternational Studies, Washington, D.C., 1989.

Denver Research Institute, Defense Industry Divers$- cation, U.S. Arms Control and Disarmament Agency Publication 30, US. Government Printing Office, Washington, D.C., 1966.

Dumas, L. G., "Making Peace Possible," in S. Gordon and D. McFadden, eds., Economic Conversion, Ballinger Publishing, Cambridge, Mass., 1984, 67-85.

Evans, D., "Budget Pressure, End of Cold War Bring- ing Changes," Chicago Tribune, October 29,1989, 1.

Korb, L. J., "How to Reduce Military Spending," The New York Times, November 21, 1989, 23.

Lynch, J. E., ed., Economic Adjustment and Conversion of Defense Industries, Westview Press, Boulder, Colorado, 1987.

Melman, S., Pen tagon Capitalism, McCraw-Hill, New York, 1970.

Pasztor, A., and R. Wartzman, "As Defense Industry Shrinks, Suppliers Face Widely Varying Fates," nie Wall Street Journal, May 24, 1990, A8.

Reddy, L.. How U.S. Dqmse Industries View Divers$- cation, Center for Strategic and International Studies, Washington, D.C., 1991.

"Sen. NUM on Vision of Military," The New York Xmes, April 20, 1990, A10.

U.S. Congressional Budget Office, The Economic and Budget Outlook: Fiscal Years 1991-1995, U.S. Gov- ernment Printing Office, Washington, D.C., 1990a.

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THE FUTURE OF THE U.S. DEFENSE INDUSTRY