Defense Industry Models Must Change to Draw New Investors

By McAleese, James | National Defense, June 2001 | Go to article overview

Defense Industry Models Must Change to Draw New Investors


McAleese, James, National Defense


For decades, we referred to the "defense-industrial complex" as if contractors were merely captive extensions of the Defense Department. It is clear, however, that last summer's Wall Street abandonment of traditional aerospace and defense stocks and the current debate over the potential cancellation of several high-visibility programs call for the creation of a new "national-security business" model.

That model must integrate the long-term needs of the nation's defense with the shorter-term scrutiny of shareholders on Wall Street.

Two messages should be made clear during the ongoing Quadrennial Defense Review by the Bush administration. First, the Defense Department must have a robust long-term defense industrial base to support the administration's strategic objectives, such as a national missile defense, tactical air superiority, precision-strike and deep-strike capabilities, tactical airlift, command and control, as well as airborne surveillance and jamming.

Such focus drives the need for "leap-ahead" technologies in key areas. However, breakthroughs in critical "leap-ahead" technologies endorsed by the administration are tied directly to defense-unique subsystems and stand-alone technical capabilities. Specifically, it is less likely that major breakthroughs in these "leap-ahead" technologies will occur at the platform level. Rather, such breakthroughs are much more likely to occur at the subsystem level, such as electronic countermeasures, fire control, sensors and integrated communications, among others. This is a fundamental shift from the traditional philosophy that focused on plat forms, not subsystems.

Second, the defense industrial base must be well capitalized, in order to drive those breakthroughs in "leap-ahead" technologies. Given the cost-accounting structure of government contracting, contractors in defense-unique, research-intensive areas must have constant capital infusion, via issuance of stock or debt, to develop new areas of technical expertise or even to capitalize substantial portions of the front-end of major production programs. There is a direct correlation between the ability of contractors to get access to capital and investors' perceptions of the ability of those contractors to generate reasonable return-on-investment.

Shorter-term "value investors" will accept strong cash flow and reasonable profit, even in a mature industry with such limited top-line growth, so long as there is "controlled-risk." Simply put, from an investor's perspective, the immediate value of a particular stock is a function of current corporate assets, plus the projected future "value" of the company. This is at the heart of almost all stock-valuation models. But while projected top-line growth will have a proportionate effect on future "value" projections, risk has a much greater adverse impact on stock valuations. Consequently, true value investors often will invest in undervalued companies with strong business fundamentals and controlled-risk-even with modest growth in projected sales--over companies with large growth potential, but major risk, as in the "dot.coms."

While many government officials support increases in defense spending, the future of the Pentagon's budget cannot be predicted. Under the Bush administration, defense dollars are competing against tax cuts, and reforms in Medicare, Social Security and education.

Nevertheless, literally billions of dollars can be capitalized by shareholders in a true controlled-risk environment. This requires consensus between key government leaders, shareholders, and industry management on a clear approach to generate a reasonable annual return-on-investment with con trolled-risk.

Government officials, industry management and shareholders should work hand-in-hand in the following areas:

* Completing the long-overdue consolidation of the excess capacity in the mid-tier defense industrial base. …

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