Defense scandal backlash could cut profits

Just as the tarnish from thousand-dollar hammers and overpriced coffeepots was being scrubbed from the defense industry's image, it has been hit with a scandal that may have a deep, lingering effect on profitability. Wall Street analysts and defense company officials are worried that angry congressmen will tighten procurement requirements in the wake of the Department of Justice investigation into alleged bribery and bid rigging by consultants, contractors, and Pentagon personnel. The added red tape would hamper the $120 billion industry - affecting contracts for years to come, they say.

``The impact of this will be over the next three years,'' says Paul Nisbet, a defense analyst with Prudential Bache Securities, a New York brokerage. ``It will provide further justification to reduce defense spending and tighten procurement procedures. ... It plays into the hands of those trying to put on more restrictions, which is going to lower industry cash flow and earnings.''

The investigation, which may involve as many as 100 contracts worth billions of dollars, has already apparently nullified a small but growing movement among Pentagon officials and congressmen who were concerned that procurement reform measures may have gone too far, these analysts say.

Thus far, the sole glimmer of good news for investors has been that defense stocks have not taken a nose dive. They were already riding low in the water, making it difficult to push them lower, industry analysts say. Most bobbed along with the rising market this week.

McDonnell Douglas was one of about 20 companies that have either received federal search warrants or subpoenas in the investigation. The St. Louis-based defense giant's stock rode over waves of negative publicity.

But although the Standard & Poor's index of aerospace stocks is at its highest level this year, and has been performing well, defense stocks are still valued as much as 40 percent below the market, Mr. Nisbet says.

Since Defense Secretary Frank Carlucci III ordered a $33 billion cut earlier this year, the expectation is that the 1989 defense budget will fall (after adjustment for inflation) about 1 percent, to $299 billion.

With fewer dollars available, many contractors are shedding their defense divisions. While the industry restructures, the biggest contractors are already struggling as Congress and the Defense Department have cut tax breaks and required them to pay a larger share of research and development and capital equipment.

The scandal ``will probably tend to slow down the procurement machine,'' says Lawrence McCracken, a spokesman for Raytheon, a Lexington, Mass., defense company that primarily supplies missiles and radar equipment. ``We're hoping [Congress] will see that the system exists to root out corruption and that we don't need a whole series of new laws.''

A backlash of increased procurement restrictions could be a problem for companies that are already struggling as the defense budget is trimmed to reflect glasnost and a new administration.

``What it does is worsen the aroma around the industry,'' says William Deatherage, a defense analyst at Dean Witter Reynolds, a brokerage. ``We had begun to see a turn in Congress, and people thought that maybe the procurement reforms had gone too far. Now all of a sudden this comes up.''

On Tuesday the House Ways and Means Committee moved to repeal the completed-contract method of accounting, a tax benefit that primarily affects defense companies. That slap could be followed by others.

``There's been a lot of talk that the system is still broken, and that we need more rules and regulations,'' says Alexis Allen, a spokeswoman for the Aerospace Industries Association (AIA). ``We agree with Secretary Carlucci that this is a people problem.''

In the wake of questionable payments to defense companies, such as those reimbursing executives who boarded their dogs at kennels, a slew of restrictions have impinged on defense profits during the past two years. Several defense industry associations, including the AIA, sponsored a recent study showing that these restrictions could cut profits on future programs by 23 percent.

There is disagreement, however, about just how much money the defense industry is making. The General Accounting Office reported in December 1986 that ``defense contractors were 35 percent more profitable than commercial manufacturers during 1970-79 and 120 percent more profitable during 1980-83.''

``Since 1983, the GAO has been pushing for a defense contractor profitability reporting program,'' says one GAO official, who requested anonymity. ``We have been singular in our approach. Nobody has wanted this except us. Right now there is no data available to clearly see what profits are resulting from government policies.''

At present, the defense industry has a net profit margin of about 4 percent, estimates Value Line Investment Survey, a New York investment research company. Nisbet says the actual figure may be closer to 2 or 3 percent of sales, compared to 4 or 5 percent for civilian manufacturers.

The government can suspend a company from bidding on new business if it is indicted. A guilty plea can result in the cancellation of a program, and a company can be prevented from bidding on new work for up to three years.