For contractors, a retreat but not a rout in Pentagon spending

For America's military contractors, the latter half of the decade will not be as fancy a party as was the first half. But it won't turn into a beggars' banquet, either.

A Democratic Congress is rolling up its sleeves to deal with Ronald Reagan's 1988 and '89 Pentagon budget proposal totaling $626 billion. Analysts predict a solid slowdown in the rate of increase in defense spending, and even some real decreases in spending through the end of the decade.

For big companies like General Dynamics, Rockwell, McDonnell Douglas, and a horde of subcontractors, the array of weapons programs - from F-15s to Trident submarines to B-1 bombers - is unquestionably thinning.

The biggest new bonanza, the Strategic Defense Initiative,'' has managed to leave defense contractors feeling ambivalent: On the one hand, government funding is significant; on the other, there is considerable doubt about whether the space-shield concept will ever actually fly.

Such uncertainties and slowdowns do not, however, indicate a return to the gaunt, post-Vietnam decade of the '70s, which saw a real decline in the defense industrial base, when military contractors were diving like lemmings into the unexpectedly chilly waters of non-defense product lines.

``We are reaching a defense spending plateau, but it's a plateau on top of a mountain,'' says George Brown, a defense analyst with Data Resources, a Lexington, Mass., research firm.

Mr. Brown says current agreements for military hardware already in the pipeline will carry many contractors through 1988 and '89. With spending cuts in Washington, there will be stretchouts (reduced yearly production) on those contracts and a slashed labor force.

Defense dollar cuts, Brown says, will likely result in the loss of as nearly a quarter of the 676,000 new defense jobs added during the past few years. Shipbuilders, steelmakers, and semiconductor manufacturers will feel the pinch most.

Aerospace, consulting, data processing, plastic products, and computer equipment producers will see a slowdown in the rate of spending growth from 14 percent in recent years to the 2 and 3 percent range. Defense electronics companies, however, will continue to see good growth, with research-and-development budgets booming.

Still, there will be fewer large weapons programs to hand out, and the remaining contracts will tend to come in bigger monetary lumps. An example is the $45 billion advanced tactical fighter program, which has recently had the likes of Lockheed and Boeing, McDonnell Douglas and Northrop, vying for a piece.

``It's a more competitive market,'' says Lawrence McCracken, a spokesman for Raytheon, a Massachusetts-based maker of missiles and radar equipment. ``But the last few years we've been very successful winning second-source contracts.

Taken together, increased competition, slower defense spending, and heightened scrutiny of contractor profits will tend to:

Cause defense companies to try to enhance profits by expanding arms sales to third-world and other nations.

Push prime military contractors to bring more work in-house, cutting off smaller subcontractors and resulting in some business failures.

Prompt the Pentagon to tap its estimated $200 billion in funds from past years that remain unspent.

Even with these downside effects, however, it's clear that there are still some reasonably good times ahead.

The rest of the '80s will not be ``years of desperation'' as were the '70s, analysts say. And unlike their civilian counterparts, defense companies won't respond to the instinct to move strongly toward other, perhaps civilian, product lines during these slower times.

There are three main reasons. First, although the rate of defense spending has been slowed, outlays will remain at historically high levels.

Second, it is also clear that profitability remains healthy - to say the least. Despite new Pentagon guidelines aimed at reducing the amount of profit in military contracts, those contracts will continue to provide earnings far higher than can be attained doing comparable work in the civilian sector.

The General Accounting Office reported last month that ``defense contractors were 35 percent more profitable than commercial manufacturers during 1970-79 and 120 percent more profitable during 1980-83.'' Defense analysts conclude that even with the Pentagon changes in contract letting, it will still be far more profitable to produce guns than butter.

Finally, defense analysts say the biggest reason military contractors won't be diversifying heavily is that they remember vividly the spate of financial fiascos caused by diversification into the civilian sector in the '70s. A quick list includes:

Lockheed's unsuccessful venture into commercial aviation, which cost it an estimated $2.7 billion on its L-1011 commercial jet program.

Rockwell's attempt to build pleasure boats and color television sets, before it got out of those businesses in 1980.

Northrop's $25 million to $30 million write-off on its nuclear reactor piping business - not a huge amount by today's standards, but a lot during the slim '70s.

Boeing's stab at mass transportation and farming. The former project reportedly lost the company more than $100 million when Boeing tried to build a space-age trolley car. Boston mass transit officials are still running some 120 of the sophisticated trolleys that have doors that stick, air conditioners that don't work when it's hot, and a tendency by the entire vehicle to derail on tight turns.

``These companies tried to diversify in a major way in the early '70s and it didn't work,'' says Christopher Demisch, a defense industry analyst with First Boston.

``They moved into areas like waste management, mass transportation, and farming, and the results were disastrous,'' he says. ``Given a sharp remembrance of how badly those diversifications failed, there's going to be a tendency to mind the store, batten down the hatches, and try to squeeze out incremental productivity.''

If past busts aren't enough to steer defense contractors away from civilian-sector ventures, there is always last week's announcement by General Dynamics that it would write off $420 million of its investment in Cessna Aircraft Company. The move comes just over a year after it paid $663 million for the light plane manufacturer. About 90 percent of General Dynamics business is government.

There are, of course, exceptions to the rule. McDonnell Douglas in recent years has invested heavily in its information systems division and in its commercial transport division. The information systems group is still struggling to stay in the black, and the commercial transport portion faces stiff competition.

Nearly 70 percent of McDonnell's business remains devoted to government contracts for aircraft like the Air Force's F-15 fighter and the Navy's carrier-based F/A-18A Hornet.

``We've always worked toward a goal of balance,'' says John L. Cooke, a McDonnell spokesman. ``We'd like to be 50-50 - to bring up our commercial business to the same level as our government business.''

All in all, the word ``slowdown'' as applied to the years through 1990 begins to seem inappropriate - and defense is obviously good business for the long run. Other businesses see this fact, particularly the more traditional civilian-sector manufacturers which have struggled in the face of foreign competition..

As pressure from foreign companies impinges on US companies, analysts say, a natural gravitation is developing in which shaky ones seek the import-safe harbor of the defense industry.

General Motors, the world's largest automaker, has been struggling recently to sell cars at a profit. Yet it decided just last year to take the plunge and pay more than $5 billion to acquire Hughes Aircraft, one of the nation's largest defense electronics and aerospace companies.

Industry specialists say the move came at a time when GM profits were being battered by imports. The purchase was also motivated by the desire to possess Hughes technology at a time when Defense Department research spending is on the increase - and because some of the technology could transfer to the automobile side.

``It's a long-term business opportunity'' for GM, says David Cole, an auto industry analyst with the University of Michigan, ``and it's certainly attractive to have the Hughes technology.''

Less charitable observers suggest General Motors is only the most obvious example of a trend by embattled companies to buy into the defense pie. Ford (though not as embattled as GM) is rumored to be interested in acquiring Lockheed. Chrysler, which sold its M-1 tank business to General Dynamics in 1982, is also said to be considering diving back into defense work.

``I know of one manufacturer that couldn't make it in the heavy-equipment business, so it got into the defense industry where it's a bit easier,'' says William J. Weida, a professor of economics at Colorado College and former Defense Department economist.

``It is certainly a haven in which business doesn't have to confront foreign competition,'' says Walter Adams, a professor of economics at Michigan State University. ``It's one area where you can shoot fish in a rain barrel.''

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