The plight of the metal benders

WASHINGTON — The recent upheavals at Bethesda, Md.-based Lockheed Martin Corp. raise a troublesome question for the military electronics industry: can the traditional airframe manufacturers afford to maintain a substantial in-house electronics capability at a time of stagnant defense procurement budgets?

by John Rhea

WASHINGTON — The recent upheavals at Bethesda, Md.-based Lockheed Martin Corp. raise a troublesome question for the military electronics industry: can the traditional airframe manufacturers afford to maintain a substantial in-house electronics capability at a time of stagnant defense procurement budgets?

The companies are caught in a crossfire. On one side is the Pentagon`s insistence on state-of-the-art — and affordable — electronics built from commercial off-the-shelf (COTS) technology, which their vertically integrated structures of the past cannot fully exploit. On the other are the innovative, specialized electronics firms, which live by exploiting this opportunity.

In the case of Lockheed Martin, the issue surfaced in late October with the resignation of Peter Teets as president and chief operating officer after the announcement that the nation`s largest defense contractor expected earnings to be cut by more than half next year, from $2.15 a share to $1. The company`s sales are running around $25 billion a year, but a shrinking cash flow and debts totaling $11 billion are making investors apprehensive.

Lockheed Martin had attempted to head off the problem a month earlier with a plan to sell off businesses accounting for $1.8 billion in annual sales. These include assets the company originally purchased from IBM, including the Space Electronics and Communications operations in Manassas, Va. Lockheed Martin also may be attempting to sell its Sanders operation in Nashua, N.H., which never was part of IBM. The ostensible purpose for the proposed sales is to concentrate on the company`s core business of building aircraft and space vehicles.

Ironically, it is these and similar operations that hold the brightest long-term promise. At least they did when Lockheed Martin originally bought the Manassas and other operations from IBM, where they were part of that company`s Federal Systems Division. IBM also wanted to focus on its core business — computers — and the specialized military electronics operations reportedly brought top dollar.

Lockheed Martin officials should also realize a significant cash infusion by getting back to basics. Although it may take a few months to work out the details of a divestment, the specialized electronics operations would make a natural fit for many of the second-tier system prime contractors down the food chain from the "big three" of Lockheed Martin, Seattle-based Boeing Co., and Northrop Grumman Corp. in Los Angeles.

Taken together, the experiences of these three companies are illustrative. They were all focused on the metal bending business at the height of the Cold War, but their paths have since diverged. Although Boeing once maintained a formidable electronics capability at its Kent, Wash., space center to keep track of its vendors, its subsequent acquisitions of McDonnell Douglas and Rockwell International have put it squarely in the airframe business.

Northrop Grumman went in the opposite direction. Its predecessor companies were, respectively, an across-the-board supplier of aircraft to the U.S. Air Force (including substantial overseas sales) and the U.S. Navy`s favorite aircraft builder. Yet today the company`s business is almost entirely electronics. In fact, it was Northrop Grumman`s electronics expertise that led the Justice Department to shoot down the proposed merger with Lockheed Martin.

This situation didn`t arise overnight. General Dynamics Corp., now based in Falls Church, Va., also was once the Pentagon`s top contractor and had its feet firmly planted in the electronics and airframe businesses. It has since undergone a full-scale dismemberment to concentrate on a few profitable enterprises, and Wall Street has applauded that decision.

The picture that emerges is that the days of the one-stop defense contractor are coming to an end in today`s COTS environment. In short, the totality of a contractor does not necessarily exceed the sum of its parts.

Undersecretary of Defense John Hamre, never one to shun a colorful insight, commented early last month that the fault was Wall Street`s for its myopic view. "The stock market has pummeled our top defense contractors in past weeks," he said, criticizing what he called the "herd mentality" among institutional investors that is creating "wounded defense companies." His point is that the Defense Department must have enough qualified bidders to assure sufficient competition to give the government — and the taxpayers — their money`s worth.

Hamre is right when he criticizes investors for favoring high-flying Internet companies that have never been on the same planet as profit-oriented established companies that have contributed to national defense. But that`s not the whole story. Maybe Wall Street knows something that the Pentagon doesn`t.

For openers, not all the Pentagon primes and subs are suffering financially. The ones that are adjusting to the changing ground rules are thriving by concentrating on doing what they do best. Boeing, for example, recently wrested away from Lockheed Martin a contract for spy satellites with a potential value of $5 billion. This had historically been Lockheed Martin`s home turf.

What Boeing does best in this case is integrating complex systems and thus adding value. Lacking the electronics expertise of Lockheed Martin, Boeing logically turned to outside specialized suppliers. The net result: the Air Force considered the Boeing proposal more innovative than was Lockheed Martin`s.

This is not a new idea. The automobile industry crossed this Rubicon decades ago. Of the traditional Big Three in that industry, Chrysler was consistently considered the most innovative in implementing new electronics technology because, unlike its rivals, it did not have an in-house electronics capability as General Motors did with its Delco subsidiary and Ford with the former Philco operation. Without an electronics operation that needed orders to keep its doors open, Chrysler was free to turn to the merchant market for the best available technology.

Another example from IBM`s experience may be helpful. As part of its drive to focus on its core computer business, the company spun off its moribund typewriter operation in Lexington, Ky. That operation, previously burdened by being forced to contribute a share of its sales to the corporate research and development fund, could never turn a profit. Advances in electronics never had much to do with typewriters anyhow, so the new company blossomed once that burden was removed.

The same lack of synergism is becoming evident in the defense industry. It is not clear that putting electronics and metal bending under the same roof creates the necessary economies of scale. The situation is reminiscent of a metaphor I once heard in a somewhat different context: why buy a cow when milk is cheap?

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