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Finance on the front line: defense contractors are benefiting from new controls their CFOs have installed - U.S. defense budget and industry rapidly expanding after terrorist attacks - Government Activity - International Pages - Statistical Data Included

CFO: Magazine for Senior Financial Executives, Sept, 2002 by Roy Harris

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.

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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.

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Finance on the front line: defense contractors are benefiting from new controls their CFOs have installed - U.S. defense budget and industry rapidly expanding after terrorist attacks - Government Activity - International Pages - Statistical Data Included

CFO: Magazine for Senior Financial Executives, Sept, 2002 by Roy Harris

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