The New! Improved! Military-industrial Complex

The budget squeeze has prompted a defense industry shakeout, giving an edge to companies that upgrade weapons rather than replace them

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The old wisdom among military contractors is that defense spending comes and goes. And for the next few years, it will be going.

During the early Reagan years, the defense budget rose dramatically, from $180 billion in 1981 to $295 billion in 1985. Since then, inflation and a modest reduction in appropriations has reduced the Pentagon's purchasing power by nearly 2%. And with Gramm-Rudman still with its foot on the brakes of federal spending and the Democrats firmly in control of the Congress, further declines in the overall Pentagon budget can be expected.

Some areas will be harder hit than others, but perhaps the greatest cutbacks will come in the purchase of what defense planners call new "platforms" -- aircraft, ships, and tanks. The Reagan buildup has already provided the Navy with its 600-ship fleet, the Army with brand-new fleets of tanks, troop carriers, and helicopters, and the Air Force with squadrons of new fighters, bombers, and intercontinental missiles. While a few programs are still in the last phase of production, others have been dramatically cut back in the Administration's 1988 budget. Congress can be expected to cut even further.

At the top of the defense industry, the prospects for a severe downturn have already caused serious jitters. When the Air Force, for example, looked for bids to manufacture its new advanced-technology fighter, or ATF, a potential $40-billion contract, none of the major aerospace companies felt they could take the risk. Contractors realized that the days are gone when ever-escalating military budgets protected contractors from a project cancellation. Gone, too are cost-plus contracts in which the Pentagon protected its contractors from cost overruns. Now that the watchword is "fixed price," the contract to build a new-generation plane with all manner of space-age electronic gadgetry could be a very mixed blessing.

As a result, the ATF, if it is to be built at all, will be built by one of two teams of contractors -- in the process, setting what defense officials predict will be a precedent for future weapons programs. On one side of the ATF competition are Lockheed, General Dynamics, and Boeing; on the other, Northrop and McDonnel Douglass. Each team is expected to receive $691 million to produce prototypes. Aerospace analysts estimate that each side's cost for the prototypes will run to $1 billion. The winners will undoubtedly recoup their front-end loss from the proceeds of the final contract. The losers will not.

Collaboration among otherwise fierce corporate competitors, however, is only one sign of the times. Another more fundamental one has been the wave of consolidation that is sweeping through the defense industry. The acquisition of Hughes Aircraft by General Motors brought two big Pentagon suppliers under one corporate roof. So did the merger of satellite manufacturers General Electric and RCA. Unisys now teams two companies, Burroughs and Sperry, each of which had substantial computer sales to the Pentagon. And there were other reorganizations involving respected names in defense contracting: Singer, Hazeltin, Loral, Litton Industries, and TRW.

But perhaps the most significant of all these moves has been Lockheed's recent takeover of Sanders Associates Inc., a manufacturer of sophisticated electronic equipment for Navy fighters and attack aircraft. Last year, Lockheed paid $1.2 billion for the New Hampshire company, with its 8,500 employees and sales of $885 million. The price was high, but the strategy was clearly calculated: in an era in which the Pentagon will be spending less money buying new platforms, it will be spending more money buying upgraded electronics systems for the platforms it already owns.

"The electronics portion of the defense industry is going to do better than average," predicts Robert Kugel, aerospace analyst for the New York City investment house of Morgan Stanley & Co. "This is not only because of the prospects of the retrofit market, but also because the electronics on new platforms continue to increase as a percentage of the total cost."

As a result, other electronics firms will continue to attract lucrative Pentagon contracts. Consider Pacer Systems Inc., in Billerica, Mass., for example, which works with military weapons labs to test and implement new electronic components for ships and planes. Over the past two years, Pacer has watched its sales soar from $12 million to $26 million. "The systems houses and electronics builders are clearly the principal beneficiaries of the new directions in defense," explains Jack Rennie, a former Navy test pilot who founded and presides over Pacer.

A current contract indicates why a company like Pacer is so well positioned. Pacer today is working with the Navy to update its P-3 antisubmarine patrol plane. New sensors and faster computers on the planes will allow the planes to track a quieter generation of Soviet submarines. Fully equipped, a new P-3 costs about $30 million, and we expected to stay in operation for 15 years. But with the new gear, the plane's life span could be stretched to 30 or even 35 years.

"I think we will see very few new aircraft or ships in the next few years," predicts Rennie. "The industry writers still equate the top 50 companies with the whole defense industry, so you will see bleak headlines. But for small firms in upgrade areas, the outlook is actually quite strong."