RAND Analyst Participates in DSB Task Force Analysis

David S.C. Chu, Director of the Arroyo Center and Vice President of the Army Research Division, recently served as a member of a Task Force affiliated with the Defense Science Board (DSB) to find new ways to craft military contracts and acquisition practices. The Pentagon had asked the DSB to determine whether DoD acquisition policies, processes and regulations have supported or weakened rational and economic business practices within the primary vendors of military equipment and to make recommendations on what DoD can do on its own or with Congress's help to improve the defense industry's future financial prospects.

Why Was the Task Force Formed?

In the late 1990s, the stocks of many major defense companies had fared poorly, especially when compared with the broader S&P indexes. In 1999, the combined market valuation of the top ten defense companies was about equal to that of Proctor & Gamble by itself. By the end of 1999, the defense sector's market devaluation posed many potential problems. Low stock prices made companies ripe for hostile takeovers. Defense industry workers watched the value of their 401K plans and stock options plummet. At the same time, the stock valuations of technology firms that compete with defense contractors for workers experienced a huge rise as "dot-com" mania swept the investment community. 

The Clinton administration was concerned that the sharp decline in defense industry stock prices posed a threat to the United States' defense industrial base. The Defense Department therefore chartered the task force in January, 2000.

Undertaking the Analysis

The task force conducted a three-month qualitative review. Its members went to Wall Street to meet with stock analysts and mutual fund managers and also spoke to the CEOs of the top defense companies. The task force received briefings on relevant research.

When they met with the analysts and mutual fund managers, they found a consistent theme among them. Until the 1990s, defense stocks were seen as comparable to utility stocks: boring but steady. The flurry of mergers and acquisitions in the mid-1990s, however, changed that view. Investors saw defense stocks as exciting, and the stocks were bid up based on the potential of huge returns. The earnings turned out to be disappointing, however. When a new Secretary of Defense curtailed future mergers, defense stocks took a tumble.

Another effect of the mergers and acquisitions was that the debt of many of these companies increased substantially, and their credit ratings declined. Despite this, some analysts who saw promise for the defense industry expected "recapitalization" of the early 200s.

Conclusions and Recommendations of the Task Force

The Task Force found that the defense firms' problems were caused by a combination of factors, including mistakes by the companies themselves and fundamental changes in the defense business with the end of the Cold War.

The task force reached the following conclusions and recommendations in their report:

  1. The situation was not a crisis. However, if the problem continued on its present course, the DoD wouldn't have access to the best technology available in the marketplace. This lack of access could result in a future crisis.

  2. The rate of return on defense contracts is too low, especially Research and Development (R&D). This is one of the reasons why the rate of return is much higher for some companies whose main business is not for the Department of Defense. The DoD should allow higher profit margins on DoD contracts.

  3. High-technology firms would like much stronger control over their intellectual property rights. The DoD needs to reconsider its policy on this issue.

  4. Defense companies should take a different view of compensation and ensure that their recruitment and retention efforts reflect current market conditions.

  5. Currently, defense companies must return efficiency cost savings to the government. The task force recommended that the Pentagon share these savings with the companies to encourage future efficiency measures.

  6. More in-depth research on earnings is needed.

The Climate Has Now Changed

Since the release of the task force's report in the middle of 2000, the defense industry's financial prospects have changed. Many companies have already started to correct their own performance problems. The Internet bubble seems to have burst. Defense industry stocks are now performing better, which has removed some of the pressure to create a new paradigm for the defense industrial base.