From Pentagon, a Buy Rating on Contractors

By JOE NOCERA
At the Cowen & Company military industry investment conference on Wednesday, the breakfast speaker was a man named Ashton B. Carter. A former academic and industry consultant, Dr. Carter, as he likes to call himself — he has a doctorate in theoretical physics, in case you were wondering — is the Defense Department’s under secretary for acquisitions, technology and logistics. That is, he’s the Pentagon’s chief weapons buyer.

This article from the NY Times. Original at http://www.nytimes.com/2011/02/12/business/12nocera.html.

Cowen is a small firm, but its military analyst, Cai von Rumohr, has been on the beat for more than 40 years. Companies tend not to turn him down when he invites them to his conference. W. James McNerney Jr., the chief executive of Boeing, would be making a presentation later in the day, as would executives from Northrop-Grumman and other contractors. Big institutional investors like T. Rowe Price were out in force.

As was the Defense Department. In addition to Mr. Carter, a top Naval official was scheduled to present the next afternoon.

If you’re wondering what high-ranking Pentagon officials were doing at an investment conference, well, suffice to say that this was not a question on the minds of the people in this room. They’ve gotten used to it. For the last few months, beginning with a secret meeting last October, Defense Department officials have been making the rounds of analysts and investors.

Their main message, to put it bluntly, is that even in an era of tighter budgets, the Pentagon is going to make sure the military industry remains profitable. “Taxpayers and shareholders are aligned,” Mr. Carter intoned on Wednesday. Then he laid out a series of reforms that he said would both increase competition and maintain, as he put it, “profitability over the long term” — a phrase he repeated for emphasis.

He told the assemblage that the Pentagon would frown on mergers among the five giant military contractors — the so-called primes: Lockheed Martin, General Dynamics, Raytheon, Northrop-Grumman and Boeing. However, he added, the Defense Department was going to encourage mergers among smaller military contractors. And, he said, “we will be attentive” to innovative smaller companies that provide services (as opposed to weapons systems) to the Pentagon.

If you were an investor in the military industry, would you find this useful information? You bet — this is the stuff that can move markets. Although Mr. Carter made several references to “market forces,” the only market for the military industry is the government, which spends some $400 billion a year on weapons systems and other purchases. In economic terms, the Pentagon is a “ monopsony,” a single buyer with life-or-death power over its vendors. If the Pentagon wants the military industry to be healthy and profitable, it can pretty much ensure that outcome.

Not being an industry insider, however, I found myself a little taken aback by Mr. Carter’s “guidance.” Monopsony or not, why should the Pentagon be talking up the stocks, even implicitly, of the companies it buys from? Why was Mr. Carter going out of his way to talk to investors and analysts? Didn’t he have more important things to do?

The answer, I eventually learned, has to do with something that happened a very long time ago, and goes under the category of “Be careful what you wish for.” Let’s just say that banking isn’t the only industry where the government has allowed a handful of companies to become too big to fail.

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The year was 1993. Bill Clinton was the new president, and Les Aspin was his defense secretary. As recounted later by Norman R. Augustine, then the chief executive of Martin Marietta, Mr. Aspin called together about 15 C.E.O.’s of the prime military contractors for a dinner at the Pentagon. Mr. Augustine would memorably label this dinner the Last Supper.

Mr. Aspin and several other high-ranking Pentagon officials (including Mr. Carter, who was then an assistant secretary of defense) had brought the group together to send a tough message. With the Berlin Wall gone, the Soviet Union dissolved — and the Pentagon budget flat-lining — the Defense Department was no longer willing, as Mr. Augustine later recounted, “to pay the ballooning overhead” of all those contractors. In no uncertain terms, Mr. Aspin told the group that they needed to start merging.

“The rest is history,” Mr. Augustine later wrote. “General Electric Aerospace merged with Martin Marietta, which combined with Lockheed. McDonnell Douglas joined Boeing. Grumman joined Northrop. When the dust had cleared, there were only a few firms left standing.” Five, to be exact.

The Last Supper has become part of the lore of the military industry — though partly that’s because Mr. Aspin’s prediction about tighter Pentagon budgets turned out to be so wrong. “On the day George W. Bush took office,” said Loren B. Thompson, a well-known military consultant, “defense spending was around $300 billion.” Today it is more than double that amount, around $700 billion. The wars in Iraq and Afghanistan — not to mention the Pentagon’s voracious appetite for expensive weapons systems, and the lack of competition among the remaining contractors — have been a gold mine for the Big Five.

Not surprisingly, for most of the first decade of the 21st century, the stocks of these companies soared. But after peaking in 2008, they came crashing back to earth. Which, for the Pentagon, has turned out to be a problem. These companies need access to the capital markets, which is more difficult when their stocks are down. And the Pentagon simply can’t allow them get into serious financial difficulty; there are just too few of them. “What we can’t afford from the defense perspective is a sick industry,” said Jacques S. Gansler, a former procurement official for the Pentagon who teaches at the University of Maryland.

There is another problem, too. Having reached that $700 billion mark — which amounts to about half the discretionary spending in the entire budget — there is simply no way military spending is going to keep growing the way it has, not in these difficult economic times. (When the defense budget is released on Monday, it is expected to increase only slightly.) Recognizing that leaner times lay ahead, Defense Secretary Robert M. Gates made a speech last May acknowledging that Pentagon budgets were unlikely to rise substantially any time soon, and laid out a plan to create new efficiencies and increased competition among the companies.

Since then, several weapons systems have been canceled. Others are in jeopardy. Military contractors have been told that they have to become more efficient. New military contracts will try to impose some financial risk for the companies — so if there are huge cost overruns, the companies will have to absorb some of the pain. (On the other hand, companies are going to be allowed to pocket 50 percent of any savings they produce.)

Is it any wonder that the stocks dropped so precipitously, and that investors are nervous? Mr. Carter notwithstanding, taxpayers and shareholders are decidedly not in alignment: the tougher the Pentagon gets with its contractors, the better it is for taxpayers and the worse it is for shareholders. And yet it can’t get too tough, because if it is, the companies will start running into financial trouble, which means the stocks will sink even further and the companies will start to have trouble raising capital. This is the bind created by the Last Supper.

Now can you see why the Pentagon has taken to talking up the industry to the investment community? With one side of its mouth, the Pentagon is saying it is going to be more tough-minded in its approach to military contractors than ever before. But with the other side of its mouth, it is telling investors not to worry: the profits will be there, no matter what. Partly, this is political posturing; the Pentagon worries that the contractors and their allies in Congress will push back if the Defense Department doesn’t emphasize industry profit. Still, the Pentagon’s two-sided stance is not a terribly tenable position and requires much papering over. Hence Mr. Carter’s road show.

The sidling up to investors actually began last October, when the deputy defense secretary, William J. Lynn III, held a private meeting for about a dozen Wall Street analysts, laying out the Pentagon’s cost-cutting plans in astonishing detail. Indeed, according to Reuters, which uncovered the meeting, the analysts were sworn to secrecy. Although this would seem to violate, at the least, the spirit of transparency that Americans expect of market participants, notes of the meeting became public only after Reuters exposed it. (A military consultant named James McAleese published his notes on his Web site a few days after the Reuters story broke.)

Whatever the ethics of this meeting — and the Pentagon insists that nothing new was divulged during the session — it appears to have had an effect. If you look at the stock charts of the Big Five, you’ll see that they all started to rise around October. Imagine that.

In December, Mr. Carter and several other Pentagon officials attended a conference thrown by Credit Suisse and Aviation Week magazine. When I first spoke to Mr. McAleese, he casually mentioned that he had organized a private meeting for the Pentagon officials with institutional investors only. Then his cellphone went dead. Four days later, when I spoke to him again, he denied any such private meeting had taken place, and blamed his previous statement on the fact that “I hadn’t slept in three days.” (A Pentagon spokesman also denies a private meeting took place.)

Since then, the stocks have been booming. Maybe I’m putting too much emphasis on the Pentagon’s road show, but it is hard to imagine it’s had no effect at all.

Does the country need a healthy military industry? Of course. It also needs efficiently built weapons. But the Pentagon road show hardly seems like the right way to go about it. Mr. Carter and his minions might be better served taking steps to unwind some of the damage done by the Last Supper, perhaps by letting some of those midsize companies grow into prime contractors, or by taking steps to break up some of the modern behemoths.

But never mind. Next week, there’s an Aviation Week conference where Mr. Carter is supposed to speak. And there’s another conference a few weeks after that. I hear Mr. Carter will be there, too.