the health of the u.s. defense industry “in the eye of a ... · • rockwell defense to boeing...
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Defense-IndustrialInitiatives Group
February 19, 2004 1
The Health of the U.S. Defense Industry“In the Eye of a Perfect Storm”
Pierre A. ChaoSenior Fellow and Director Defense-Industrial Initiatives
National Defense Industrial Association2004 Munitions Executive Summit
Tampa, FL
February 19, 2004
Defense-IndustrialInitiatives Group
February 19, 2004 3
Elements of the “Perfect Storm” - Procurement WasCut Dramatically After the Cold War...
� Procurement account down 40% 1990-1996� RDT&E account down 8% 1990-1996� Meanwhile, Personnel down 13%, O&M up 4% and Milcon up 11%
0
1 0 ,0 0 0
2 0 ,0 0 0
3 0 ,0 0 0
4 0 ,0 0 0
5 0 ,0 0 0
6 0 ,0 0 0
7 0 ,0 0 0
8 0 ,0 0 0
9 0 ,0 0 0
1988
1989
1990
1991
1992
1993
1994
1995
F is c a l Y e a r
$ M
illio
ns
Pr o c u r e m e n t
R D T & E
Source: U.S. Department of Defense
� Ammo budgets drop from $5.6 billion in 1985 to $1.5 billion
Defense-IndustrialInitiatives Group
February 19, 2004 4
Elements of the “Perfect Storm” –Changes in Business Philosophy
� 1980s/1990s saw� Attacks on the multi-industrial firm/conglomerate
� 1980s hostile takeovers/leverage buyouts – break up the conglomerate
� Be number one/number two or get out
� Stick to your knitting
� More sophisticated and active investors� Diversification undertaken at investor portfolio level rather than
corporate
Defense-IndustrialInitiatives Group
February 19, 2004 5
Phase I Consolidation Triggered By Budget Declines
Time Frame 1986 - present• Chrysler Gulfstream to LBO house• Ford Aerospace to Loral• Goodyear Aerospace to Loral• Hercules Aircraft to BFGoodrich• LTV (Vought) to Loral and Northrop Grumman• GE Aerospace to Martin Marietta• Penn Central Vitro to Tracor• IBM Federal Systems to Loral• Honeywell / Alliant Techsystems spin off• Ryder / Aviall spin off• Unisys to Loral• Hercules Space to Alliant Techsystems• Black & Decker PRC to Litton• TRW Defense to Northrop Grumman• Alcoa Thiokol Propulsion to Alliant Techsystems
KeyCharacteristics
� Started when defense budget turned down� Buyers are strategic players as well as financial
Examples
Defense-IndustrialInitiatives Group
February 19, 2004 6
Elements of the “Perfect Storm” –There Was a New Environment After the Cold War
� Weapon systems more complex and expensive to developExample: F-22 fighter development costs 2.5 times F-16
� Fewer programs are launchedExample: Fighters introduced in 1940s: 17 in 1980s: 2
in 1950s: 9 in 1990s: 2 in 1960s: 9 in 2000s: 1
in 1970s: 6
� Programs take longer to go from development to production, more"stretch outs"
� Higher technical, political and service-specific risk
� RESULT: Need to reduce industry capacity and create larger companieswith "deep pockets“ and a breadth of capabilities/programs
Defense-IndustrialInitiatives Group
February 19, 2004 7
Elements of the “Perfect Storm” –Pentagon Established Consolidation Rules
� Secretary of Defense Perry hosts "Last Supper" and announcesthat the Pentagon cannot afford to keep everyone in business
� Industry told it must consolidate, but Pentagon says it will notdecide who or how (directly...still has influence throughprogram decisions)
� Pentagon establishes a merger review process (focuses onconcentration within industry segments, access to technologiesand ability of companies to survive)
� Pentagon agrees to reimburse merger-related restructuringcosts in exchange for cost savings and lower prices
Defense-IndustrialInitiatives Group
February 19, 2004 8
Phase II Consolidation FollowedSector Consolidation/
Horizontal• Gain critical mass within a sector• Primary benefits are consolidation savings, eliminate capacity
Time Frame
Examples • GD Missiles to Hughes• GD Fort Worth to Lockheed• Sundstrand DataControl to AlliedSignal• GD Space Systems to Martin Marietta• Norden Systems to Westinghouse• Grumman to Northrop• FMC / Harsco JV• Teledyne Data to Litton• Allison Engine to Rolls-Royce• Bath Iron Works to General Dynamics• Allied Signal Actuation to Moog• AEL to Tracor• Magnavox to Hughes• Chrysler Technologies to Raytheon• Teledyne Vehicle to General Dynamics• Texas Instruments / Hughes to Raytheon• GenCorp Aeroject and United Technologies• Santa Barbera to General Dynamics• Newport News to Northrop Grumman
KeyCharacteristics
1992 - present
Defense-IndustrialInitiatives Group
February 19, 2004 9
Elements of the “Perfect Storm” –Key Issues Related to Vertical Integration
� Mass becomes even more critical to the industry as budgets continue dropping
� Technologies shifting - electronics becoming the value-added component� Example - first generation/unguided missiles the key was speed and
propulsion, key players were chemical/motor players; now the key is thesensor and guidance, key players are electronics houses
� Who should be prime? - metal bender or electronics house
� Players vertically integrate to understand the technology or satisfy markettrend
� Electronics related budgets have suffered the least
� Sources of technical innovation
Defense-IndustrialInitiatives Group
February 19, 2004 10
Phase III Consolidation Followed"Broadening"/
Vertical Consolidation• Broaden business base and increase industry critical mass• Add complementary businesses• Reduce overhead, R&D, cross sell products
Time Frame
Examples • E-Systems to Raytheon• Lockheed with Martin• Loral to Lockheed Martin• Rockwell Defense to Boeing• Westinghouse Defense to Northrop Grumman• McDonnell Douglas to Boeing• Logicon to Northrop Grumman• Northrop Grumman to Lockheed Martin (failed)• GEC Marconi to British Aerospace• Federal Data to Northrop Grumman• Motorola Fuze by Alliant Techsystems
KeyCharacteristics
1995 - present
Defense-IndustrialInitiatives Group
February 19, 2004 12
A Decade of Consolidation...
Source: SDC.
Year of Announcement 199019881980 1982 1984 1986 1992 1994 1996 1997 1998 1999
First Wave Second Wave
BAE Systems
EADSMatra
LFK (Deutsche Aerospace)
Royal Ordnance Plc.
Matra-Hachette-Guided-Weapons
Australian Air Academy
AELVitro
GDECordant
Tracor
BAE Systems
Engesa SA (Brazil)
Northstar Tech Inc. – General
Saab AB (Investor AB)
Urban Aircraft Operational Svc.
British Mnfr & Research Co. Ltd.
Cap Scientific, Yard Systems
British Aerospace Simulation
Reflectone Inc.Nanoquest – Defense Products Bus.
Satellite Management Intl.
Mauser-Werke WaffensystemeBAE-Radar Activities
British Aerospace – Missile Ops
Shorts-Armoured Vehicle Bus
AWA Defense Industry Pty. Ltd.Advanced Technologies & Engine
AMS – Missiles System Div.Hyundai Space & AircraftHunter Aerospace Corp.
Marconi GEC
Aerospatiale
DASAMarconi Space
Hughes Electronics
Loral
BDM (Carlyle)
Northrop Grumman
Lockheed Martin
Raytheon
Fairchild Weston Systems Inc.Loral
Honeywell-Electro-Optics
Ford AerospaceBDM International Inc.
Librascope
IBM–Federal SystemsUnisys Defense
General Dynamics–Ft. WorthMEL
Lockheed
General Electric–Aerospace
General Dynamics Space Business
LTV–Aircraft OperationsGrumman Corp.
Ryan AeronauticalKistler Aerospace Corp.
Alvis Logistics–EDD Business
HughesGeneral Motors
BET PLC's Rediffusion Simulation
MagnavoxREMCO SA
STC PLC–Navigation SystemsTRW-LSI Products Inc.
Corporate JetsE-Systems
Chrysler Techn. AirborneTexas Instr. El. Defense
Martin Marietta
Northrop
Raytheon
Northrop – West Virginia
Raytheon – Flight Simulation
Raytheon Co-Plant, Quincy
LTV–Missile Business
General Dynamics Missile Division
BoeingRockwell
Argo SystemsLitton Precision Gear
SkyBridge LP (Alcatel Alstrom)Hughes Electronics Satellite
Boeing
McDonnell Douglas
TASC (Primark)PRC (Black & Decker)
General Instruments–DefenseVarian–Solid State Devices
Taratin
Litton IndustriesAvandale Industries
Gould Ocean System Division
Logicon
Westinghouse El. Defense
Comsat
TRW Defense
Defense-IndustrialInitiatives Group
February 19, 2004 13
Has Resulted in A Three-Tiered U.S. Defense Industry..
$-
$5,000
$10,000
$15,000
$20,000
$25,000
$30,000
Lock
heed M
artin
Boein
g
Ray
theon
North
rop Grumman
G
enera
l Dyn
amics
Unite
d Technologies
L-3
Communicatio
ns
GE Airc
raft E
ngines
IT
T Defense
Allia
nt Tec
hsyste
ms
Tex
tron
$50 bil $112 bil
Rock
well Collin
s
Defense-IndustrialInitiatives Group
February 19, 2004 14
Reflecting a True "Peacetime" Industry...
"Peace" Cold War "Peace” 1927-1933 1980's 1995-2002
UA&T 42.3% Boeing 16.9% Boeing 36%Curtiss-Wright 38.7% McDonnell Douglas 11.3% Lockheed Martin 17%Douglas 8.6% United Technologies 9.1% Northrop Grumm. 13%Glenn Martin 5.4% Lockheed 8.4% Raytheon 10%Consolidated 2.9% General Electric 5.8% General Dynamics 7%Great Lakes 1.8% General Dynamics 5.7% General Electric 6%Grumman 0.3% Rockwell 5.6% L-3 Communications 3%
Raytheon 5.4% United Technologies 3%Martin Marietta 4.9%
Concentrated Fragmented Concentrated
Defense-IndustrialInitiatives Group
February 19, 2004 15
Top 20 Defense Contractors 1980 2002General Dynamics Lockheed MartinMcDonnell Douglas BoeingUnited Technology Northrop GrummanBoeing RaytheonGeneral Electric General DynamicsLockheed United TechnologiesHughes SAICRaytheon TRWTenneco HealthnetGrumman L-3 CommunicationsNorthrop General ElectricMotor Oil Hellas United DefenseChrysler DyncorpRockwell HumanaWestinghouse HoneywellSperry BAE SystemsFMC BechtelMartin Marietta ITTHoneywell TextronLitton Triwest
Source: Department of Defense
Pure DefenseAero/DefenseMultiPure Commercial
Defense-Industrial Ghetto?
Defense-IndustrialInitiatives Group
February 19, 2004 16
(Preliminary Analysis)
Defense Margins Have Improved, BUT…Industry Average Operating Margin (weighted by revenue)
0%
2%
4%
6%
8%
10%
12%20
02
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
CSIS DefenseIndex
Sources: FactSet, S&P Compustat, EnergyInformation Administration, CSIS Analysis
Notes: 1) CSIS Defense Index comprises 36 publicly-traded companies with majority revenues derivedfrom US defense business.(2) S&P Sub-sector constituents accurate back to 1994; composition held constant for years 1980 to1993.
Defense-IndustrialInitiatives Group
February 19, 2004 17
� What are the alternative investments when you consider thedefense sector?
Source: CSFB survey
Entire Market
Transportation
Technology
Commercial Aero
Capital goods/Industrial
Defense Industry Does Not Operate in a Vacuum
Defense-IndustrialInitiatives Group
February 19, 2004 18
Industry Average Operating Margin (weighted by revenue)
0%
5%
10%
15%
20%
25%
30%20
02
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
CSIS DefenseIndex
S&P 500
S&P CapitalGoods
S&P Pharm &Biotech
S&P TechnicalHardware
S&P Software &Services
Publicly OwnedElectric Utilities
Defense Industry in Context – Lowest Returns of Peers
Sources: FactSet, S&P Compustat, EnergyInformation Administration, CSIS Analysis
Notes: 1) CSIS Defense Index comprises 36 publicly-traded companies with majority revenues derivedfrom US defense business.(2) S&P Sub-sector constituents accurate back to 1994; composition held constant for years 1980 to1993.
Defense-IndustrialInitiatives Group
February 19, 2004 19
Investors Prized the Industry for its Stability� What is more important to you: top-line growth or consistency of
earnings?
Growth
ConsistencySource: MSDW survey
2002
1999
“Predictability of source andlevel of earnings, as opposed tosmoothness”
Growth
Consistency
Defense-IndustrialInitiatives Group
February 19, 2004 20
The Disconnect – Defense More Volatile Than ExpectedIndustry Revenue Volatility versus Average Operating Margin (weighted by
revenue)
R2 = 0.0888
0%
5%
10%
15%
20%
25%
0 5 10 15 20 25 30 35 40 45 50 55 60 65 70
Revenue Volatility Index
Ave
rage
Ope
ratin
g M
argi
n
V olatility of DoD Procurement & RDT&E Outlays = 22.32CSIS Defense Index
S&P 500S&P Capital Goods
S&P Pharm & Biotech
S&P Softw are & Services
S&P Tech Hardw are
Publicly Ow ned Electric Utilities
Notes: 1) CSIS Defense Index comprises 36 publicly-traded companies with majority revenues derivedfrom US defense business. (2) S&P Sub-sector constituents accurate back to 1994; composition heldconstant for years 1980 to 1993. (3) Operating Margin data averaged between 1980 and 2002, exceptfor Electric Utilities (1991-2002 only).
Sources: FactSet, S&P Compustat, EnergyInformation Administration, CSIS Analysis
Defense-IndustrialInitiatives Group
February 19, 2004 21
Key Questions on Future Industry Structure...
LSI
Pure Outsourcing Vertical “Light”
Global Player
Systems / Component
Vertical Integrator
How does DoD manage?
Defense-IndustrialInitiatives Group
February 19, 2004 22
Key Questions on Future Industry Structure...
� Defense vs. National Security
� Is Homeland Security real?
� Who will respond?
� Civil-Military Integration
� Transformation
� What does it mean?
� Who will be the true leaders? Traditional players or new comers
Defense-IndustrialInitiatives Group
February 19, 2004 24
Procurement and RDT&E Outlay as % of Total DoD Outlay
0%
5%
10%
15%
20%
25%
30%
35%
40%
45%
50%
1980
1982
1984
1986
1988
1990
1992
1994
1996
1998
2000
2002
2004
E
2006
E
TotalProcurement andRDT&EOutlay as %of DoDOutlay
Procurement Outlay as% of DoDOutlay
RDT&EOutlay as %of DoDOutlay
Source: Budget of the UnitedStates Government, Fiscalyear 2004
Budget Pressures – Investment Still “Bill Payer”
Defense-IndustrialInitiatives Group
February 19, 2004 25
• How long before the next downturn?• Iraqi War costs
• At what point does the supplementals tactic end
• Budget deficits
• 2004 Presidential elections
• FY06 onwards budget issue
• Growth in end strength
• O&M “death spiral”
• Upgrade versus replace/modernize
• Baby Boomer retirement
• Cost risk
Budget Pressures
Defense-IndustrialInitiatives Group
February 19, 2004 26
Defense = Alliant Techsystems, General Dynamics, Grumman, Litton, Lockheed Martin, Martin Marietta, Northop, Northrop Grumman, Newport News
Defense Electronics = E-Systems, L-3 Communications, Logicon, Loral, Raytheon, Tracor Source: Factset, CSFB Analysis, CSIS Analysis
0
100
200
300
400
500
600
700
800
900
12/3
1/90
10/2
5/91
5/19
/92
12/0
9/92
7 /02
/93
1/24
/94
8/17
/ 94
3/10
/ 95
10/0
2/95
4/24
/96
11/1
3/96
6/09
/97
1 2/3
0/9 7
7/24
/98
2/17
/99
9/09
/99
3/31
/00
1 0/2
3/00
5/17
/01
12/1
3/01
7/10
/ 02
1/31
/03
8/25
/03
DefenseDefense Electronics
S&P500
Stock Market Already Factoring in a Decline
Defense-IndustrialInitiatives Group
February 19, 2004 27
(Preliminary Analysis)
Even Though Defense Companies Have Lowered DebtIndustry Average Debt to Capitalization (unweighted)
0
10
20
30
40
50
60
70
80
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
CSIS DefenseIndex
S&P 500
S&P CapitalGoods
S&P Pharm &Biotech
S&P TechnicalHardware
S&P Software &Services
Sources: FactSet, S&P Compustat, CSISAnalysis
Notes: 1) CSIS Defense Index comprises 36 publicly-traded companies with majority revenues derivedfrom US defense business.(2) S&P Sub-sector constituents accurate back to 1994; composition held constant for years 1980 to1993.
%
Defense-IndustrialInitiatives Group
February 19, 2004 28
(Preliminary Analysis)
Bond Markets Still Rate Industry Near “Junk”Average Debt Ratings (unweighted)
2.00
3.00
4.00
5.00
6.00
7.00
8.00
9.00
10.00
11.00
12.00
13.00
14.00
15.00
1991
1992
1993
1994
1995
1996
1997
1998
1999
2000
2001
2002
2003
CSIS DefenseIndex
S&P 500
S&P CapitalGoods
S&P Pharm &Biotech
S&P TechnicalHardware
S&P Software &Services
AAA
AA+
AA
AA-
A+
A
A-
BBB+
BBB
BBB-
BB+
BB
BB-
Sources: FactSet, S&P Compustat, CSISAnalysis
Notes: 1) CSIS Defense Index comprises 36 publicly-traded companies with majority revenues derivedfrom US defense business.(2) S&P Sub-sector constituents accurate back to 1994; composition held constant for years 1980 to1993.
Defense-IndustrialInitiatives Group
February 19, 2004 30
Four Key Components
Cash margins (“return”)
Invested Capital
Growth (Revenues)
Competitive AdvantagePeriod
TechnologyPatents/IPHuman CapitalBrand
ValueDefense BudgetsCommercial AeroExports
FacilitiesMachinery/ToolsLandGoodwill
Material InputsLabor“Defense” overheadCost of capital
Defense-IndustrialInitiatives Group
February 19, 2004 31
� Strategically– Exit non-core, underperforming businesses– Move to higher valued-added, more profitable areas - “System
of systems” (which requires electronics/software expertise)
� Internally– Re-engineering efforts– Cost-reduction plans
� Government policy– Defense Science Board look at industry margin rates and
ability to retain cost savings– Proposed changes to R&D margins, cost saving retentions
Addressing Return/Margins
Defense-IndustrialInitiatives Group
February 19, 2004 32
Addressing Return/Margins - Six SigmaThree of Fortune’s Top Ten Most Admired Corporations Uses Six Sigma
(three of the top four manufacturers)1. Wal Mart 6. Johnson & Johnson2. Southwest 7. Microsoft3. Berkshire Hathaway 8. FedEx4. Dell Computer 9. Starbucks5. General Electric 10. Proctor & Gamble
Eight of Fortune’s Top Ten Most Admired Aerospace/Defense Co’s Uses Six Sigma1. United Technologies 6. General Dynamics2. Lockheed Martin 7. Textron3. Northrop Grumman 8. Rockwell Collins4. Boeing 9. Goodrich5. Honeywell 10. Raytheon
Defense-IndustrialInitiatives Group
February 19, 2004 33
Addressing Return/Margins - Six Sigma
Can Generate Significant Savings
Motorola 1996-2001 $16 billion 4.5% of revenues
Allied Signal 1998 $500 million 9.9% of revenues
General Electric 1996-1999 $4.4 billion 1.2% of revenues
Honeywell 1998-2000 $1.8 billion 2.4% of revenues
Ford 2000-2002 $1 billion 2.3% of revenues
Defense-IndustrialInitiatives Group
February 19, 2004 34
Addressing Return/Margins - Six SigmaAnd Can Be Rewarded by Wall Street
Malcolm Baldridge Award Winners
Stock Perf vs. S&P
1995 6.5 to 1
1996 4.0 to 1
1997 3.5 to 1
1998 2.9 to 1
1999 2.6 to 1
2000 4.9 to 1
2001 4.4 to 1
Defense-IndustrialInitiatives Group
February 19, 2004 35
� Strategically– Continued consolidation of the second and third tiers of the
industry– Longer-term pressure for international consolidation
� Internally– Continue to eliminate excess facilities– Lean manufacturing efforts / recapitalization
� Government policy– Defense Science Board look at progress payments, paid cost
rules– Pentagon changes to paid cost rules, progress payments
Addressing the Invested Capital Problems
Defense-IndustrialInitiatives Group
February 19, 2004 36
� Defense electronics/information systems faster growing part ofthe defense budget– As electronics-related budgets increase– As electronics/info systems become a greater portion of the
weapon system
� “Vertical integration”
� Government policy– Mergers and acquisitions/competition rules
Addressing the Growth Problems
Defense-IndustrialInitiatives Group
February 19, 2004 37
� Strategically– Remain in high value-added areas - increasingly systems
integration, software, information systems expertise� Internally
– Recruitment and retention of new talent (CRITICAL)– “Archiving” knowledge and expertise of existing talent
Addressing the Competitive Advantage Problems
0
5
10
15
20
25
1 8 -2 4 2 5 -2 9 3 0 -3 4 3 5 -3 9 4 0 -4 4 4 5 -4 9 5 0 -5 4 5 5 -5 9 o ve r6 0Ag e (Y e a r s )
% o
f Wor
kfor
ce
Source: Booz Allen & Hamilton