More Chips, Fewer Choppers

New high-tech weapons mean fatter margins for defense contractors

On the battlefield, tank crews live and die by one simple rule: The guy who fires first -- and most accurately -- wins. Fortunately for the U.S. 3rd Infantry Division, locked in battle with Iraq's Republican Guard outside Baghdad, defense contractor General Dynamics Corp. (GD ) has turned the Abrams M1 tank into the ultimate infantry weapon. Thanks to three high-tech makeovers, tank commanders can locate their foes in any weather, navigate with up-to-the-minute electronic maps, spot targets for fighter pilots, and -- yes -- fire their guns more quickly and accurately than their enemies. "No warrior in history has had that kind of real-time battlefield information," says Paul Funk, a military consultant and retired U.S. Army Lieutenant General who commanded an armored division in Desert Storm.

It's not just the tank commanders for whom warfare has gone high-tech. The Pentagon's switch to digital weaponry and computer networks has forced the top defense contractors, including General Dynamics, Northrop Grumman (NOC ), Boeing (BA ), and Lockheed Martin (LMT ), to refocus their priorities from bending metal to writing software code and pulling together complex electronics systems. Lockheed Martin's Systems Integration unit, with $9.6 billion in sales last year, accounted for 36% of the company's total revenues, and 48% of its operating profits. As recently as 1996, that business accounted for just 22% of sales and 8% of profits.

This makeover represents a change for defense contractors. Criticized over the years for being too bureaucratic, too cumbersome, and too cautious, they are trying to operate more like Silicon Valley startups. "It's clear that there has been a paradigm shift, a major defense transformation," says Kenneth C. Dahlberg, executive vice-president at General Dynamics' $3.7 billion Information Systems & Technology unit.

The switch wasn't optional -- it was the only choice for any contractor eager to survive the industry's shakeout. Back in the boom years of the 1980s, more than a dozen new weapons were introduced, including the M1 tank and the B-1 bomber. But as the sector shrank in the 1990s, only a handful of major new weapons systems debuted. Since the first Gulf War, annual defense procurement has been cut in half and many once-rich production contracts have petered out. Instead of ordering new planes and tanks, the Pentagon has concentrated on upgrading the high-tech IQ of gear it already owns or producing new information systems that make its troops and weapons more effective.

The contractors see not only revenues rolling in but also fatter profit margins. New high-tech systems are subject to the same development contracts as traditional weapons -- which caps their profitability. But once projects move into production, defense contractors can improve their margins by reducing costs and by performing technology upgrades, which are not subject to the same profit caps. General Dynamics, for instance, received just single-digit profit margins when it produced M1 tanks at $1.7 million apiece. But when it upgraded M1s to add the latest electronics gear for $4.1 million per tank, its profit margins hit double digits, according to Richard Aboulafia, of Teal Group, a defense and aerospace consultant group. "They perceive the network itself as the land of higher margin," he says.

Not a single major defense contractor is sitting this one out -- but neither will they share equally. The initial winners are contractors such as Northrop Grumman and General Dynamics that noticed the shift in demand early and adapted quickly. They were able to buy up choice defense technology companies before prices headed out of sight.

Indeed, no company adjusted faster than Northrop Grumman Corp. -- largely because it had to. After losing the competition for the F-22 Raptor fighter to Lockheed Martin and Boeing in 1991, its traditional business was drying up. Since then, the Los Angeles giant has acquired 16 companies -- most of them involved in high-tech specialties such as radar, computer systems consulting, and satellite communications. CEO Kent Kresa forced executives to focus on high-tech equipment upgrades rather than on giant new aircraft projects. Their big winner was the Joint STARS program -- stuffing 20 recycled Boeing 707s full of digital electronics gear in a contract worth about $15 billion. The mission: tracking enemy armor from the air in any weather, including sandstorms.

Thanks to its acquisition binge, Northrop Grumman's revenues have surged from $7.6 billion to $17.2 billion over the past two years, and net income hit $672 million last year. Investors have enjoyed the transition, too: Its stock price has risen 72%, to $87, over three years.

The same can't be said for the defense contractors that came late to the party. They and their investors are suffering for their tardiness. Boeing Co., for instance, paid $3.7 billion in cash for satellite-maker Hughes Space & Communications in 2000. But shareholders griped the price was too high, since the acquisition came at the peak of the stock market bubble. "They overpaid, and they misread the market," says Richard Turgeon, director of equity research at Victory Capital Management, which owns 2 million shares of Boeing stock.

Overall, the new emphasis on digital weaponry has been a mixed bag at best for investors. Over the past year, the Standard & Poor's aerospace and defense index has declined 32%, compared with a 23% drop for the S&P 500-stock index. The September 11 attacks provoked talk in Washington and Wall Street of substantial increases in defense spending, which triggered a runup in stock prices for defense contractors. But prices dropped quickly in 2002, after the actual procurement spending came in lower than expected.

Moreover, many of the high-tech systems contracts will be more profitable only if companies figure out how to lower their costs even while they're delivering new products and services. Already, Boeing has run into costly production problems with its Hughes satellites. "It's not that obvious the contractors are going to generate a better return," says Chris Mecray, an analyst at Deutsche Bank.

And while high-tech systems offer new avenues for revenues and profits, they also continue to shift the focus away from the contractors' traditional businesses. If digital weaponry works as planned, the military may be able to do more with less. That could mean purchasing fewer $4.5 billion aircraft carriers, or pushing back the delivery time or the number of aircraft ordered in the megabillion-dollar F-35 fighter program. "Network-centric war is clearly the future," says Jon B. Kutler, CEO of Quarterdeck Investment Partners LLC, a defense industry investment bank. "What we don't know is to what degree there are growing pains."

There's still time for the contractors to adjust to the changes. The Iraq war will necessitate replenishing the stocks of missiles, helicopters, and bombs. Already, on Apr. 2, Raytheon Co. (RTN ) received an order from the U.S. Navy to accelerate its production of Tomahawk cruise missiles. But unless these companies master the art of high-tech warfare, they'll miss out on their best chance to bounce back from the industry's worst-ever slump.

By Stanley Holmes in Seattle, with Stan Crock in Washington and Christopher Palmeri in Los Angeles

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