Defense Conversion: a Tale of Two Methods

While some defense contractors are reducing their reliance on Pentagon buying, others concentrate on buying up competitors

Since 1989, real-dollar Pentagon purchases from the private sector have shrunk more than 30%. Companies that profited from the Carter-Reagan buildup have been challenged to downsize and turn to new markets. How have they done?

The record is not encouraging. More than 1 million private-sector defense jobs have disappeared since 1989, and more are going. Surveys from defense-dependent regions suggest that despite high levels of expertise, only about one-third of laid-off workers find jobs that match previous pay, benefits, and job security. In California, a recent Rand study found that 39% of those leaving the aerospace sector between 1989 and 1994 did not reappear on the state's employment rolls.

Defense companies, which usually have better technology and employ disproportionate numbers of scientists and engineers, are a likely venue for pioneering new products and markets, as are the regions that host them. Many have considerable cash reserves available for this effort. Companies like Boeing and General Electric have an outstanding track record in serving both military and commercial markets. Economies like Seattle, Minneapolis, and Silicon Valley diversified brilliantly after past periods of deep defense cuts.

Mixed picture

What is happening this time? In three years of research, we found remarkable diversity in conversion performance among both large and small firms. Some large prime contractors, like Rockwell International, Hughes Aircraft, and TRW, have ambitiously committed earnings and organizational resources to move aerospace and communications technologies into civilian products. Each has lowered its dependence on military sales to less than 40%. Hundreds of smaller contractors have followed suit.

In contrast, large contractors like Lockheed Martin, Northrop Grumman, Loral, Litton Industries, and McDonnell-Douglas are jockeying for position in shrinking military markets, using their cash reserves to buy up competitors. Each remains more than 70% defense dependent. Time after time, incipient conversion efforts have been squelched as management energies are devoted to blending huge companies and paying down debt. Northrop's takeover of Grumman, for instance, stopped Grumman conversion efforts on Long Island, while Loral's acquisition of Los Angeles-based Librascope sidelined conversion there.

Company-based conversion success would yield more than just good jobs and incomes in hard-hit regions. The more military contractors, large and small, lower their defense dependency and diversify into nondefense markets, the less the Pentagon need worry about maintaining the defense industrial base and surge capacity. And taxpayers will be spared the dangers of a few oversized defense-dependent giants pressuring Congress and the Pentagon for pricey futuristic weapons systems not in the nation's security interests. Presidential candidates would be spared the embarrassment of appearing at cold-war weapons factories to promise their survival.

Will taxpayers save?

Is the Pentagon managing this process well? The Defense Department appears to be bungling it. On the one hand, Secretary William Perry, a former defense-industry executive, is vigorously pursuing dual-use initiatives aimed at lowering the institutional barriers between civilian and military production by overhauling the procurement system and awarding dual-use-technology grants. Defense hopes to save taxpayers money and stretch defense dollars further. These measures are helping some firms weather post-cold-war cuts and move into commercial markets.

But these signals are countermanded by the Pentagon's acceptance of and subsidies for mergers that eliminate competition. On the basis of purported future savings for taxpayers, newly melded companies may charge off against current contracts the costs of plant closings, worker severance pay, and golden parachutes for displaced executives. It is not clear that capacity is being eliminated, nor that downsizing will produce future savings, nor that taxpayers should relieve the private sector of the risks and costs of market change.

But the main point here is the tilting of the playing field. Companies that wish to acquire a commercial partner to gain commercial-market expertise receive no such special treatment, even though they may end up better Pentagon suppliers as a result.

And Wall Street? Defense-company profits and price/earnings ratios are up, unprecedented in periods of defense downsizing and attributable to friendly new Pentagon practices. Investment bankers are busy engineering lucrative mergers. Disparaging commercialization efforts, they are successfully forcing companies like TRW and Rockwell to divest their defense divisions for the short-term profits that "pure play" defense firms provide.

Wrecking-ball approach

Newly combined companies are milking mature weapons contracts and pursuing profitable arms exports, also with taxpayer subsidies. When backlogs begin to fall, they simply buy another defense division and keep the game going.

This amounts to a wrecking- ball approach, indifferent to the potential that resides inside defense contractors or the workers and regions affected. Such myopic behavior jeopardizes innovation and longer-term investments. Our studies show that it takes two, three, five, or even seven years for firms of all sizes to shift gears. Those with committed managers and sources of bridging finance often make it, creating hundreds of jobs and stabilizing host regions.

This is a critical year. Lockheed Martin and Loral are about to finalize their marriage, and more megamergers are in the works.

The Pentagon should immediately eliminate consolidation and arms-export subsidies. Before greater concentration is permitted, Defense and the Justice Department should evaluate the implications of relying on a few surviving giants. National security, price, and planning implications of dual-use versus pure play should be debated. Modest and successful conversion programs should be amplified, not subjected to the budget ax.

The payoff? A leaner and more flexible defense establishment, a stronger economy, and more and better jobs.

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