Cuts Won't Cut It Anymore

If you were a defense worker in 1993, there's a good chance you lost your job. But if you were an investor, odds are you doubled your money as defense stocks soared. Only part of that scenario may hold for 1994. The industry may cut 100,000 more jobs on top of 600,000 so far. What's less certain is Wall Street's mood. "Some companies are no longer going to have continued earnings growth. It's just not in the cards," says Dan Tellep, chief executive of Lockheed Corp.

Washington will cut arms outlays 11% this year, to $62 billion--39% below the 1987 peak of $101 billion. In 1993, industry cost-cutters raced ahead of the Pentagon, slashing jobs--especially in managerial and engineering ranks--faster than revenues tailed off. As productivity soared, the companies reaped the rewards. Meanwhile, the industry scaled back on reinvestment that had been essential during the cold war to prepare for the next round of programs.

SLENDER PIPELINE. McDonnell Douglas Corp. illustrates the benefits of such moves. Starting in 1990, it pared 40% of its work force. Combined with aggressive debt reduction, that helped operating profits soar last year, from $346 million to an estimated $940 million, and the company's stock price more than doubled. Overall, net profit margins for 22 major aerospace companies rose 17% in 1993, to $7.2 billion, estimates analyst Howard Rubel of Goldman, Sachs & Co.

With only a handful of new weapons systems in the Pentagon pipeline, arms makers will find it tougher to show such improvement this year. Cost-cutting may allow some to post profit gains again, but as revenues shrink, even the strongest will start to suffer. Lockheed faces declining orders for its F-16 fighter, a program it acquired from General Dynamics Corp. just last year. McDonnell Douglas will see cuts in its Apache helicopter and probably in its C-17 transport programs. Northrop Corp. will be especially hard-hit. Outlays for the B-2 bomber, which accounts for half its revenues, peaked at $5.3 billion in 1989. They will fall to $1.7 billion in 1994. Although Northrop's cash flow is still strong, analysts expect its stock to underperform the market.

The industry will have to go beyond mere layoffs to steady earnings in 1994. A fresh wave of consolidation looms, and some sectors will narrow to a single contractor. Lacking orders for its Seawolf submarine, Tenneco Inc. may have to cede sub building to General Dynamics' Electric Boat Div. and focus on aircraft-carrier work instead.

With stock prices high, outright acquisitions may be rare. Instead, contractors will continue shuffling assets, acquiring each other's divisions to bulk up product lines. After spending $1.5 billion last year for the F-16 business, Lockheed may sell or shutter such ventures as its commercial aircraft maintenance unit. Martin Marietta Corp. plans to buy GD's rocket-launch business.

Diversified conglomerates such as Rockwell International, TRW, and Textron may trim their defense units. Meanwhile, consolidation will let opportunistic companies such as electronic-systems makers Loral Corp. and E-Systems Inc. become leaders. With a frenzy of acquisitions, including Ford's aerospace unit, LTV's missile division, and IBM's defense computer business, Loral has built itself into a $6 billion company.

Unlike in other downturns, arms makers can't count on much relief from foreign military sales or commercial aerospace. As domestic sales plummet, exports are becoming a larger piece of total defense buisness. Even so aerospace exports fell 15% in 1993, to $6.9 billion, and should stay flat in 1994, according to the Aerospace Industries Assn. The few big orders will be hotly contested. Lockheed and McDonnell are vying for a $1.8 billion order from Israel for 20 fighter jets.

"ENDGAME." Some companies will adopt unusually radical strategies. Litton Industries Inc. is breaking into two companies: a defense-oriented electronics unit bent on survival through acquisition, and Western Atlas International Inc., a $2 billion oil-services and industrial-automation business. Some analysts think Hughes Aircraft Co. may try a similar strategy. Hughes, which gets two-thirds of its revenues from defense, is betting on new commercial ventures stemming from its military satellite business. This year, it will kick off DirecTV, a satellite service that will beam programs into homes. Spaceway, a separate satellite data system due in 1998, would blanket the U.S. with wireless video and phone service and compete with fiber-optic networks to deliver interactive programming.

Hughes's commercial push is risky, and most other defense contractors haven't gotten close to such gambles. After a year of hefty profits even as business dries up, "the question now is, where does it all end and how do you play the endgame?" asks Rubel. That's what industry executives will be scrambling to answer in 1994.