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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"SIMULATING" EFFICIENCIES AT L-3

Waugh says the greatest achievement of the Northrop finance department, though, maybe its restructuring of management compensation, using a "warranted equity value" system. The system, started in 1994, now makes up 60 percent of the company's cash bonuses, available to 7,000 of its 100,000 employees.

In the early 1990s, Waugh was looking for a metric that correlated better with stock-price movement. Northrop's earlier programs, like those used by most defense contractors, set goals based on sales, margin, and cash. That wasn't bad, says Waugh, "but you could drive cash and sacrifice margin, for example," to the detriment of the overall company.

The new compensation approach, based on a cash-flow-return-on-investment model used by portfolio managers, assigns each individual operation at Northrop an imputed stock value reflecting debt and cash flow. That value must grow during the year for any bonus to be paid, and there are no exceptions- not even for CEO Kent Kresa or CFO Waugh. Since the Pentagon offers payments for such things as achieving program milestones, there are individual incentives for doing things that benefit program results-something that did not exist under the old incentive systems.

Among the "mezzanine" defense contractors, L-3 Communications has sought to grow with small to midsize defense acquisitions. And what makes the acquisitions good deals, says CFO LaPenta, is that these targets often have been far slower than the big contractors to learn about the benefits of tight financial controls.

"Eight times out of 10 we replace the vice president of finance," he says. Like General Electric, New York-based L-3 Communications targets only those companies that are either number one or number two in their markets. Among the organizational changes L-3 installs: corporate must review new program bids, and all hires of more than $125,000 a year must go to CEO Frank Lanza and LaPenta for approval first.

The system has worked well for L-3, which has built itself into a company with $4 billion in annual sales, about eight times the size it started at in 1997. And sometimes, L-3 finds a gem among the operations that others have put on the market.

Take the Link Simulation and Training business bought by L-3 from Raytheon in 2000 for $160 million. The deal gave L-3 the world's leading flight-simulator business, with $300 million in annual sales, though losses ran about $50 million. "Here, not only the vice president of finance went, but also the controller, president, and program management," says LaPenta. "Within 60 days of acquiring the company, we cut it back to $250 million, and became more selective about bidding for business." Last year, Link contributed $35 million in operating to L-3, and LaPenta projects more than $40 million from Link this year.

POLITICAL WARS

The government has been granting the industry some breaks in contracting terms in recent years, which have been good for cash flow. Early last year, the rate of government progress payments on programs was boosted to 80 percent from 75 percent. Other restrictions were loosened on performance-based payments, allowing contractors to get paid earlier as specific program milestones are reached. And in 2000, the so-called paid-cost rule--forbidding contractors from billing the United States until the company paid its subcontractors--was eliminated.