US defense industry running full speed ahead. Backlogs, `star wars' work bolster investment outlook

Except for the taint of scandal, things couldn't be better for America's big defense contractors. The United States is in the middle of the biggest peacetime military buildup in history. Money is flowing into planes, missiles, warships, ammunition. And projects such as the ``star wars'' Strategic Defense Initiative mean more work on the way.

Unlike other heavy industries, weaponsmakers prospered right through the recession. Unlike other high-tech companies, defense producers today are flush with cash, are returning up to 25 percent on equity, and have a backlog of orders stretching years in the future.

This is because giants such as General Dynamics, McDonnell Douglas, Rockwell International, General Electric, Boeing, and hundreds of secondary contractors exist in a unique, privileged atmosphere -- one not necessarily subject to the rigors of the free market.

These companies are, however, highly susceptible to political winds. And, given the exotic, expensive nature of their work, they're prone to scandal, too. Kennels for executives' pets, $800 hammers, $600 toilet covers, fraudulent time vouchers, kickbacks, political donations, and huge cost overruns have been in the headlines in recent months. These could take their toll on the defense budget, which feeds this industry, observers say.

But it is important to keep in mind that the budget debate in Washington today centers on the rate of growth of military spending. Industry observers concur that regardless of the exact level of defense spending -- and the damage done by assorted improprieties -- the flood of money into these companies is certain to remain enormous through the end of the 1980s. Prosperous days

``It sounds like the story is that the defense industry is falling apart,'' says Paul H. Nisbet, a Prudential-Bache defense industry analyst, regarding the spate of scandals. ``The situation is very negative -- but it is more noise than reality.''

Amid this noise, Mr. Nisbet notes, the industry has been posting stronger and stronger cash flows in the past four years. The rate of gain is now slowing, he says, to ``a more acceptable level.'' According to Pru-Bache estimates, ``no firm tops out until, at the earliest, 1986, and that could be Rockwell with the B-1.'' Nisbet says most of the companies will not peak until the 1990s.

Even troubled General Dynamics, the subject of great criticism for cost overruns on its submarines, generates $3 million a day in cash and will continue to do so until at least 1987.

Given this programmed-in prosperity, Nisbet considers defense industry stocks solid investment prospects. He thinks it likely that merger and acquisition activity will hit the industry in the months ahead: ``A lot of things can happen in this group, including potential revaluation [via merger and acquisition].''

Morton L. Siegel, an aerospace analyst for Value Line Investment Survey, says he expects the fiscal 1986 budget to emerge with 5 percent real growth in the two key areas for defense contractors: weapons procurement and research and development. So far, he says, Congress is not talking about eliminating any major program, just trimming certain ones.

Mr. Siegel, too, sees mergers and acquisitions as likely in the defense industry in coming months, but he warns that defense contractors have not been particularly adept at going into businesses other than their prime military trade.

``It's possible they'll try to protect themselves against an inevitable downturn,'' Mr. Siegel says. ``But it often seems difficult for them to do both [military and civilian business]. They've been badly fooled in acquisitions in the past.''

He notes Grumman's poor performance in making buses and McDonnell Douglas's problems with its computer division. Lockheed and Boeing have also moved into the computer field -- ``which makes sense,'' Mr. Siegel says. ``But you have to ask yourself, what is it they [big defense contractors] can buy that will make a significant difference when you are talking about billions a year in military sales?'' A privileged industry

In the main, defense corporations are like most other businesses. They are owned by shareholders and out to maximize profits.

But their primary customer is Uncle Sam, their primary product is strictly for military use, and therefore these companies have a special status. Though subject to government review, their products and services are ones-of-a-kind, and thus it is extremely difficult to perform normal cost accounting in this industry.

``It's quite a different industry than autos and steel,'' says Dr. James C. Dunstan, graduate professor of business administration at the University of Virginia.

In most cases, the government cannot go to competitors for weapons, Professor Dunstan says. At the same time, without the government order these companies wouldn't even be building weapons. Nor does the government just buy ready-to-drive tanks or jets from defense concerns. It funds research, production, and even determines whether profits have been fair.

``The government has one supplier,'' Dunstan says, ``and the supplier knows it, and the supplier, naturally, wants to make decent returns.''

Jules D. LaRoque, associate professor of economics at Lawrence University in Appleton, Wis., has analyzed the relationship between defense contractors and the government and cites a troubling pattern. Once contractors begin doing work for the Defense Department, ``it is difficult to force them out; they don't really stand the test of the market.''

Dr. LaRoque says a contractor typically will ``buy in'' to defense work with a very low bid and later make up for it with cost overruns. Then, once defense work is begun, the contractor becomes privy to security information and therefore is ``locked in'' with the government for years to come.

Also prompting cost overruns are the Pentagon's high standards for products such as jets, tanks, and missiles. A defense contractor might have to make an expensive retooling effort because of design changes or new testing criteria.

General Dynamics vice-president Gorden E. MacDonald lamented this process before the Joint Economic Committee recently, noting that the design of SSN 688-class submarines was ``far more complex and difficult to work with than anticipated.

``There were long delays and huge cost overruns,'' said Mr. MacDonald, who was acting general manager of GD's Electric Boat Division. ``In addition, there were countless change orders that totally disrupted the work. We did the best we could under incredibly difficult circumstances.''

In this industry, the customer (the Pentagon) not only pays for the product but usually foots the R&D bill and reimburses for investments in plant and equipment. Moreover, defense companies often defer taxes on profits. General Dynamics, the nation's second-largest defense contractor after McDonnell Douglas (according to a Pentagon study released last week), has paid no corporate income tax since 1972. Adversarial or collegial?

Some of the defense contractor scandals are the result of outright fraud and price-gouging. But some, such as the $600 toilet covers, come because normal cost-accounting techniques do not work in the defense industry.

Many of the products are classified and are highly specialized. When accountants try to figure the costs by component, they come up with residual items that are priced way out of relation to reality: hence a $600 toilet cover.

Dr. Dunstan notes that relations between the government and defense contractors have fluctuated over the years: ``The pendulum has swung from excess profits during the Korean war, then no real profits and an erosion of the industrial base in the 1970s, to the current problem -- the government's having only one supplier [and profits therefore increasing]. The adversarial relationship is gone. Now it's more collegial.''

Under these circumstances, he asks, ``what can be done to limit the profits of a company that is the only supplier of major weapons systems?'' Dunstan, who was a consultant in the early 1970s for the Justice Department on excess-profits cases, thinks some form of regulation is necessary.

Sen. William Proxmire (D) of Wisconsin, a longtime critic of government waste, is considering legislation to reinstitute the Renegotiation Board, which, until it was disbanded in 1979, tried to regulate profits in the defense industry.

Edward M. Kaitz, a Chevy Chase, Md., specialist on the defense acquisition process, acknowledges the abuses by contractors, but he notes that, given the enormous size of many of these companies, the abuses are relatively minor. Mr. Kaitz sees signs, however, of more governmental oversight. This could, he warns, simply compound costs: ``The more you regulate [the defense industry], the longer the acquisition cycle becomes. It then takes longer to get weapons into the field.''

Robert Haythorne, a colleague of Mr. Kaitz, notes that the US has chosen ``to rely on private business to the maximum extent possible for weapons. There are not government plants to manufacture tanks.'' Hence, the profit motive is natural.

Meanwhile, with the defense budget battle still raging, political winds in Washington are likely to blow more scandals in. Pru-Bache analyst Nisbet sees these as the Pentagon conducting its contract negotiations in public: ``What is happening is very definitely a form of blackmail to impress the American public that the Pentagon is standing watch.''

Consultant Kaitz, however, is worried that ultimately these could ``destroy the consensus for defense and get some firms to move away from defense contracting.''