Budget finance home

IN THE YEAR SINCE terrorists attacked New York City and Washington, D.C., the United States and its industries have suffered in ways both unexpected and predictable. Between arming the nation for overseas conflicts and bolstering its security at home, though, the defense industry has been thriving.

Not since the Vietnam War has the defense budget risen so sharply in a single year, driven largely by the need to procure high-tech weaponry like that used in the campaign against Afghanistan, and potentially to be used in Iraq. As a result, Lockheed Martin, Boeing, Northrop Grumman, General Dynamics all weathered the bear market with relatively few scratches (at least until July). Those five industry leaders, along with many second-tier contractors, also had better-than-expected earnings in the first half of 2002.

Still, their sustained good fortune can't all be attributed to the recent turn in world events. Throughout the Cold War and into the 1980s Reagan arms buildup, the boom in defense contracting was routinely punctuated by industry tailspins.

But that isn't expected this time. After a rocky decade of decline in the industry following the Soviet Union's collapse, U.S. defense-industry leaders turned to their finance departments for help, for the most part in the late 1990s. They made major organizational changes and installed new approaches to cost control, while abandoning many old, counterproductive practices.

"There's been a broad acceptance of financial disciplines and controls that simply were absent in the Cold War environment," says Robert V. LaPenta, president and CFO of defense-electronics concern L-3 Communications Corp. No longer, he says, is finance "the short leg of the three-legged stool for many defense companies," deemphasized compared with engineering and marketing.

"It's a matter of managing the businesses as businesses," rather than seeing themselves mainly as equipment providers for the military, says Northrop Grumman Corp. vice president and CFO Richard Waugh, who has watched the industry develop over two and a half decades at the company, the last nine years as its finance chief. At Northrop, he says, finance now contributes by carefully planning the integration of its acquisitions, and with "earned-value measurement systems," which are manufacturing cost-control programs that "go down four or five or six levels to tease apart the cost of various work efforts," and help the company achieve specific reductions. To a large extent, he credits Northrop's seven-year-old compensation system, which rewards management efforts that benefit shareholders rather than merely grow the company.

The emphasis on finance is quite a switch from the old days, when the emphasis was on pleasing "the customer;' as the Pentagon has always been known. Indeed, in the bad old days, arms makers played games with their bidding strategies. "Companies asked themselves what it would take to win a program, as opposed to what the program would cost," explains LaPenta, whose industry finance experience also goes back to the 1970s. "It was a case of bidding to win it, then hoping somewhere down the road to make that money back," he says.

Waugh agrees: "In the distant past, the effort was to not worry about what the contracts say, or how we'll perform, but to be on the leading edge from a technology standpoint." Today, he believes, finance has finally become a "change agent" in defense, focusing "on winning programs at the appropriate value."

A HONDA INSTEAD OF A FERRARI

The government played a major, if accidental, role in making contractors more finance-conscious. As the 1980s wound down, the United States encouraged new competitors to enter defense production, which increased capacity while hurting old-line contractors with already-thin margins. Then, with the fall of the Soviet Union, the federal arms procurement budget started a steady decline (see chart, page 74), and the United States began pushing for industry consolidation, creating a flood of mergers and acquisitions.

"There were 55 prime contractors in the 1980s, and we're down to 5 now;' says Chris Kubasik, senior vice president and CFO of Lockheed Martin Corp. His own company, he points out, "comprises 17 of the heritage companies that would have been among those 55."

Acquirers took on massive debt. But at the same time, the government funded less and less of companies' research and development, helping heat up the corporate competition for capital. Suddenly, contractors found their finances being reviewed carefully by the investment community, which often didn't like what it saw. The total defense budget, $462 billion at its Cold War peak in fiscal year 1985 (in today's dollars), had fallen by a third in 1998, to $295 billion.

The Pentagon lowered the cost-ceilings on new weaponry, such as the F-35 Joint Strike Fighter (JSF). For the Air Force, the $37 million cost of each stealthy JSF is about the same price it pays for old-tech F-16Cs. Defense contractors began to get the message: find cheaper ways to produce high-tech arms and more efficient ways to merge, even if that meant reinventing the finance department.

"Today, cost is of the essence to the customer, because the customer doesn't have the budget it used to," explains Northrop's Waugh. He views the change in U.S. weapons-buying as similar to how a wealthy family might react to a sudden plunge in income. "When you and your wife have lots of money, you go out to buy a Ferrari and a Rolls-Royce." But in the aftermath, "you say to the wife, 'I'm not even sure you need a Lexus. And wouldn't a Honda be OK just to move the kids around in?"'

CONTRACTING AND EXPANDING

The industry's newly empowered finance executives, eager to make the best of program shrinkage, also were instrumental in helping companies define their core operations and reshape themselves to fit the revised view--starting with the sell-off of noncore operations. The most dramatic early divestiture drive was by General Dynamics Corp., based in Falls Church, Virginia, which disposed of its huge fighter-plane, missile, and space-launch businesses, among others, and at one point seemed ready to liquidate completely. Finally, it decided to focus on tanks, ships, and electronics, and began acquiring again. Acquiring companies learned--sometimes the hard way--that M&A must be done selectively and carefully. Lexington, Massachusetts-based Raytheon Co. encountered severe growth pains after its buying spree, and only lately has seemed to regain its health.

Efficiencies in The Boeing Co.'s defense programs help improve the overall corporate profit margin. The commercial airliner segment has been deflated by competition and over capacity. The conventional view among aerospace-industry watchers is that Boeing got a huge boost during Debby Hopkins's 17 months as CEO, starting in 1998, when she came from General Motors to help shape up the finance operation. (She left for a short-lived term as Lucent Technologies's finance chief.) Boeing says Hopkins's efforts to train all executives in finance principles were expanded by her successor, Michael Sears, who was in charge of development and production of military aircraft at Boeing after its merger with McDonnell Douglas.

Paul Nisbet, an analyst who specializes in defense stocks for JSA Research, in Newport, Rhode Island, praises this "new Boeing" for the openness that has evolved under Hopkins and Sears, as well as for its performance. "Boeing never said anything that was the least bit enlightening before them," he says.

WOWED ON DAY ONE

One of the most complete finance reinventions has been at Lockheed Martin, which used M&A to become both the industry's largest company--its sales will approach $26 billion this year--and for a time its most debt-laden. The quest for scale was part of the problem that came to a head three years ago for Lockheed. With profits punished by troublesome acquisitions, in 1999 CEO Vance Coffman put finance in charge of launching a two-year divestiture plan, something almost Unheard-of for Lockhead. In a program led by then-CFO Robert J. Stevens, now president and COO, the company sought to eliminate six lines of business and realign its balance sheet.