The Defense Industry

Courtney Youngblood and Jack Michel1 December 2008

Economics 345 – Public Policy Towards Business

OverviewThe industry is normally referred to as the Aerospace and Defense Industry to include both firms dealing with aerospace and defense since the two fields rely incredibly upon each other.

The aerospace industry produces aircraft, spacecraft, and their propulsion systems. The defense industry produces land, air, and sea military vehicles, satellites, weapons, and ammunition.

It is easy to see how these two overlap. Many of the companies within this industry participate in both due to the similarity of production and the idea the defense industry is considered recession proof. Boeing is an example of this. For this project – the focus is on the defense sector only (excluding firms with a primary focus on commercial aircraft [i.e. Boeing])

Why is the Defense Industry Interesting?Very Lucrative Industry

The US Government planned to spend $480 billion on defense spending in 2008.Total world defense spending was 1.2 trillion in 2006.

Very ImportantDefense is a very important function of our government and country’s existence. The United States spends almost 5% of its yearly GDP on defense.

Technological PlaygroundThe Defense industry is one of the most technologically advanced industries. Research and development is one of the common words found in this industry. Many technologies created for the military eventually find their way into civilian use.

History of the Industry #1 – Major Happenings

Historically, the defense industry is one of the oldest in existence, as arms have been manufactured for profit throughout human history. Since even before Greek Antiquity, blacksmiths and metalworkers have made swords, spears, and shields for personal and military use.

As a result, the history of this industry is one of amazing depth. Some major happenings

With the invention of gunpowder, arms making required more resources and additional skills. As a result, specialized guns makers emerged. Companies such as Colt (1847), Smith and Wesson (1855) are famous in American history. Still, many governments kept arms production under their control such as the British Royal Small Arms Factory and the United States Springfield Armory. Shipbuilding has always been a very resource intensive craft. In the 1500s, ship building firms began to appear that specialized in making ships. Government assistance was usually always required.

The defense industry we see today really emerged in the beginning of the 20th century with the need for and emergence of advanced weapons such as aircraft, complex vessels, and armored vehicles.

Governments issued their needs and firms rushed to design a product to win the contract.

History of the Industry #2 – Major Happenings

World War IIMassive war requiring full-scale industrial production for the war effort. Many companies had successful products through contracts, but almost all defense firms had business and were profitable. This was because many projects, such as the B-17 Flying Fortress, were licensed to be produced by whatever firm had production capacity.

Post World War II - Weapons Build-upDuring the Cold War years (1945 to 1991), the United States and the former Soviet Union engaged in a massive weapons build-up for both political and strategic reasons. Defense budgets were at high levels. Additionally, whenever the United States was at war, its defense spending increased and defense contractors took advantage. The same was true for countries to which defense contractors exported. This was a prime time for the defense industry

Post Cold WarUnited States government changed its military doctrine

New Policy was to be able to conduct two major regional conflicts (comparable to the 1991 Gulf War) simultaneously.

Trend of Market Consolidation

The Trend of Market ConsolidationThe Reasoning

After the Cold War, countries’ (the United States and Russia’s in particular) defense budgets reduced dramatically. The defense industry’s infrastructure would have to reduce by approximately 40% to match this change in demand. The Department of Defense hoped the mergers would decrease the amount of overall assets (primarily physical) dedicated to defense. As a result, the United States government was in full support of the push for market consolidation. As technology matures, a dominant design is established and there is pressure for firms to consolidate as fewer product offerings exist in a market

The initial reactionBetween 1993 and 1998, mergers and acquisitions occurred within the defense industry at a rapid pace. Companies such as Lockheed Martin (1994) and Northrop Grumman (1995) resulted from major mergers.Acquisitions were the most common. The major companies (the two aforementioned, Boeing, Raytheon…) gathered up the smaller ones.

Market Consolidation (Continued)United States Government Opinion Changes in 1998

The US Department of Defense rejected the merger of Lockheed Martin and Northrop Grumman along with General Dynamic’s acquisition of Newport News Shipbuilding out of fear of lack of competition. This halted the industry’s trend toward market consolidation, as the defense industry believed a mass consolidated industry was what the government wanted.

The result of the consolidation trendBy 2000, it was clear that the consolidation trend had not produced lessened assets and profits margins were reduced as had been expected in the defense industry.

9/11/01The terrorist attacks of 9/11 changed everything. The United States military spending has increased greatly since this date.

Another market consolidation trend began recently (2003)Larger companies are trying to avoid subcontracting and are gathering up many of the smaller specialized companies.

Market Consolidation (Continued)

Post 9/11/01

The Bush Effect and Recent YearsBoom years for the arms industry, with contracts for the top ten weapons contractors up 75% in the first three years of the Bush administration alone.

The biggest increases in defense spending since Ronald Reagan.

Military budget increase coupled with ongoing operations in Iraq and Afghanistan and the War on Terror created an environment in which weapons makers can enjoy the best of both worlds.

Lockheed Martin and Northrop Grumman

These are the two firms of focus for this presentationLockheed Martin and Northrop Grumman are two of the top four firms in the world’s Aerospace and Defense Industry.

Both have their operations primarily in defense related business and therefore are prime examples of top firms in the defense industry.

Lockheed Martin receives 91% and Northrop Grumman receives 78.4% of revenue from defense related operations. For comparison, Boeing (considered an aerospace company) does 50%.

2007 Rankings in the world’s Aerospace and Defense Industry (chart later in slideshow)

Lockheed Martin #1Northrop Grumman #4

History of Lockheed Martin

LockheedFounded in 1926 by Alan Loughead. In 1929, sold out to Detroit Aircraft Co., but company failed during Great Depression. Re-emerged in 1934 under a new chairman, Robert Gross.Won a contract for the P-38 Lightning, the only U.S. aircraft produced throughout the entirety of World War II. Very successful. Secretly developed the U.S.’s first jet fighter (P-80) in a secret program called “skunk works.” This program would produce many top secret designs throughout the companies history. During Cold War, primarily produced spy planes (U-2) and military transports. Many of these transports were successfully used by civilian airlines. Bribery scandal in 1970s in relation to “guaranteed contracts.”

Martin MariettaFounded in 1961 by a merger between The Martin Company and American-Marietta CorporationThe Martin Company was founded in 1912. It produced a successful bomber design in WW I. Martin was similar to Lockheed and found success in WW II aircraft production (B-26 Marauder)Focus in the 1980s was on rockets, missiles, structures, and vehicles for space missions.

Lockheed Martin resulted from a merger in 1995 between two already successful firms: Lockheed and Martin Marietta

Lockheed Martin HighlightHeadquartered in Bethesda, MDEmploys 140,000 people worldwideCurrent CEO: Robert J. StevensWorld’s largest defense contractor by revenue.

Revenues of 41.862 billion in 2007Operating profits of 4.527 billion In 2007, 91% of all revenue came from the United States Department of Defense, other U.S. government agencies, and military departments from foreign governments. Operations in aeronautics, electronic systems, information systems, and space programs.

In 2001, Lockheed Martin won the contract for the F-35 Lightning II, which is an enormous contract calling for 3,000 production units and $200 billion before any export consideration. Major Impending Dilemma

Washington Post reported in 2006 that within 10 years, 100,000 of the company’s employees would be retiring.

History of Northrop - Grumman

NorthropFormed as Northrop Corporation in 1939 by Jack Northrop, an outstanding aeronautical engineer. Won a contract for a radar equipped night fighter in 1940. The resulting P-61 Black Widow was a very successful WWII aircraft. Experimented with “Flying Wing” designsIn 1970s, F-5 Fighter was an outstanding success, which eventually led to creation of F-18 Hornet in cooperation with McDonnell Douglas

GrummanFounded in 1929 by Leroy Grumman. Primarily an aircraft producer.Found amazing success in WWII with its naval airplanes. Three major contracts were accepted (F4F, F6F, TBF Avenger)Three more major successes with the A6 Intruder and Apollo Lunar Module in 1960s and F14 Tomcat in 1970s. Products were so reliable that the company became known as the “Grumman Iron Works.”

Northrop Grumman resulted from a merger in 1994 between two already successful firms: Northrop and Grumman Aerospace

Northrop-Grumman HighlightHeadquartered in Los Angeles, CAEmploys 122,000 people worldwideCurrent CEO: Ronald D. SugarWorld’s 4th largest defense contractor by revenue

The world’s largest producer of naval vesselsRevenues of 30.148 billion in 2007Operating profits of 3.06 billion in 2007Ranks #76 on the Fortune 500 list of industrial companiesForbes Company of the Year in 2002 for its “master of the art of innovation.”Operations in aeronautics, electronic systems, information systems (and IT training), space programs, and shipbuilding.

Its Newport News Shipbuilding division is the producer of the United States Navy’s super carriers.

Provides additional services for non-defense related purposes. Northrop-Grumman is one of the largest suppliers of IT systems to the United States federal and state government. Organized into four main divisions:

Information and Services, Electronics, Aerospace, and Shipbuilding.Each of these divisions operates fairly independent.

Change in Demand – US Defense Spending as a Proportion of GDP

Change in Demand – Total US Defense Spending (In Billions)

US Defend Spending Compared to World's Defense Spending

World Military Spending

The Current State of the Defense Industry

Total RevenueThe 100 largest defense contractors generated defense-related revenues of $318 billion in 2006

Percentage of Exports (Origination) United States (52% of non-US world’s arms transfer agreements in 2006), Russia (21%), and the United Kingdom (12%).

GrowthHistorically, has not been strong and usually below averageBetween 1994 and 2007, net income growth in Aerospace and Defense was 12.5% compared to 14.6% in S&P 500. Growth picked up between 2002 and 2007 when it was 20.4% (33.3% S&P 500).

Challenges Facing Firms

Competition over contracts

Highly resource intensiveTimeFinancial CostsSkills

Firm MakeupAlthough there are more than 100 defense suppliers in the world, the market is dominated by a handful of companies. Five out of the top six companies are United States basedA large number of companies concentrate primarily on defense, but many firms within the defense industry are companies with only a small percentage of resources dedicated to defense. Appears to be a firm saturated industry.

Top Firms – 2007 Chart

Change in Competition Over Time

Competition within the industry was intense from post World War II throughout the entirety of the cold war. Competition was at its prime in the 1980s when twenty or more firms were competing over most defense contracts.

Today, competition is nowhere close to the 1980s level. The market is dominated by the top firms and the US government usually resorts to using the same six contractors for all defense needs.

Barriers to Entry

High Resource Costs

RegulationContract SystemLoyalty of customer (government)

Dominance of Market by large firmsConsolidation trendResources availabilityLoyalty (again)

Costs to Firms

Resource CostsTimeFinancial

Complex products working with brand new technologies are incredibly expensive. Consolidation has resulted in reduced transaction costsRisks of going over contracts

CollusionFirms within the defense industry cooperate together on many projects

It is difficult for one company to be able to produce all of the materials and systems that go into today’s complex military devices.A contract will be usually be awarded to a prime contractor who will then subcontract out many of the smaller tasks on the project.

One firm will produce the airframe and avionics. Another the engines. A third will add the electronic systems and so on. Usually the larger companies (ex. Lockheed Martin, Boeing) serve as the prime contractor and the smaller companies (ex. Honeywell) do the subcontracted tasks.

However, many of the larger companies continue to acquire many of the smaller and niche companies in order to avoid subcontracting.

Price and Quantity CompetionThe Defense Industry is a contract based economic system.

All contracts given to the highest quality at the lowest bidder.Two contract types:

Cost-reimbursement (cost-plus) contractsFixed-price contracts

Current Government Contracts Receiving Increased Funding in 2008

Funding (in billions of dollars)

Weapons Systems Primary Contractors

8.7 Missile defense

6.5 12 F-35 Joint Strike Fighter Jets Lockheed Martin Corp.

4.4 20 F/A-22 Raptor fighter jets Lockheed Martin

3.5 DDG-1000 Zumwalt destroyer program Northrop Grumman Corp. and General Dynamics Corp.

3.4 CVN-21 carrier replacement program Northrop Grumman

3.4 future combat systems program Boeing and Science Applications International Corp., or SAIC

3.4 one SSN-774 Virginia-class submarine General Dynamics

2.6 26 V-22 Osprey tilt-rotor aircraft Boeing and Textron Inc.

2.1 24 F/A-18E/F Super Hornet fighter jets Boeing

1.6 18 EA-18G radar jamming aircraft Boeing

15 LPD-17 San Antonio-class amphibious assault ship Northrop Grumman

Regulation in the Defense Industry

The Defense Industry is highly regulated:Contract SystemDefense Federal Acquisition Regulations Supplement Profit controls to cost allocation and reimbursement issues. Government inspectors, auditors, and technical specialists typically oversee contract administration and cost accounting practices.

Elasticity

No real substitutes existProduct Substitution:

Nonexistent – Companies must defend themselves and they must use weaponsOne choice

Upgrade or buy new

No firm substitutionWeapons contractors are the only firms able to supply weapons at the quality needed.

“Defense firms sell unique products in a monospony where the only buyer is the United States Government.”

Largely inelasticConstant demand on industry due to defense needs; demand does not change based on price changes. Contract system regulates price.

Substitutes

Predictions for FirmsFurther Consolidation

The top 10 firms in the defense industry should continue to acquire smaller defense companies as has been the trend.

Increased Profits and RevenuesDemand expected to stay constant or increase with the ever looming fear of terrorism, the needs created by two ongoing wars in Afghanistan and Iraq, and the potential for world conflict.

Need to replace aging military equipmentComplications with the new administration

Pullout from Iraq? This would certainly reduce the supplemental funding toward the United States defense budget.

Change of product priority Focus on electronics, information technology, and unmanned weaponsUS Defense policy is changing military’s tactics to emphasize these products.

Increased exports for US firmsUS government has begun to purchase more from international firms (13.5 billion in 2005 to 16.9 billion in 2006)Developing countries will need defense products as their wealth and military threat levels rise

Predictions for the MarketMilitary Spending Increase:

Replace aging equipment Replace and repair equipment used in warUpgrade the capabilities of our soldiersLong term significant military threats

Budget Pressures:Balanced budgetEntitlement Spending CompetitionDeclining Economy

Effects of Democratic control of Congress and Presidency:Iraq War pulloutSocial Program FundingAging Equipment

Investment Opportunities

Average Return on InvestmentFirm’s profits are similar to the market average

Average Growth

Recession Proof?

Investment OpportunitiesThe Last Five Years (LMT + NOC)