Drawing A Flak Attack

By Gordon Bock

Like an overburdened state trooper who pulls too many summertime speeders to the side of the road at one time, Defense Secretary Frank Carlucci has decided to turn some of the suspected culprits loose. Testifying before the Senate Armed Services Committee last week, Carlucci said he would resume payments, which he suspended only three weeks ago, to nine Pentagon contractors that are under investigation in the Government's sweeping probe into charges of bribery and bid-rigging in the defense business. "My job is not to punish companies," he said. "My job is to protect the national security."

Carlucci's reversal provided a break in the gloom engulfing the U.S. companies that sell battleships and bombers to the Defense Department. But the Secretary called the temporary suspensions a warning and vowed to take tough action against companies proved guilty of committing crimes. And even the firms shown to be innocent will face a defense-industry environment that is growing tougher all the time.

Struggling to rein in the federal budget deficit, Carlucci and Congress are slowing the runaway growth in defense spending unleashed during the early Reagan years. Some proposed weapons, ships and planes are in danger of being scrapped by the Pentagon, which would cut into the profitability of companies that have spent millions on research and development. Other projects could be postponed or stretched out. Adding to the industry's uncertainty is the question of what President Reagan's successor will do once he gets his hands on the Pentagon's purse strings. Many executives echo the fears of Grumman Chairman John Bierwirth, who says, "This industry is on the verge of a cyclical market shakeout."

The congressional crackdown on defense spending was much in evidence last week. The National Defense Authorization Act for 1989 passed by the House and Senate would increase defense spending only 2.8% next year, to $299.6 billion. That would not even match the expected 4% inflation rate. Another sign of seriousness about cutting the Pentagon budget came when the House passed a measure to expedite the process of closing 20 domestic military bases believed to be obsolete. The moves are expected to save anywhere from $2 billion to $5 billion a year.

The current defense scandal has no doubt contributed to Congress's stingy mood. In mid-June, subpoenas were issued and FBI agents staged surprise searches in more than three dozen homes and offices in twelve states. The 19 companies subpoenaed or searched, some of which are likely targets of the investigation, are a Who's Who of 19 defense contractors. Among them: Electronic Data Systems, Gould, Hazeltine, Litton, Loral, LTV, Martin Marietta, McDonnell Douglas, Northrop, Teledyne, Unisys and United Technologies. Since the raids, a federal grand jury in Alexandria, Va., has been delving into charges that some of these defense contractors and their consultants bribed Pentagon officials for inside information vital in bidding for contracts worth billions of dollars. As part of the crackdown, Carlucci last week ordered 16 defense firms to certify on future contracts that they have received no inside tips relating to the deals.

No charges have been filed in the "Pentagate" probe, and many companies and individuals in question vehemently deny any wrongdoing. But Government lawyers believe a stream of indictments will flow from the affair, which could make it the defense-industry equivalent of Wall Street's insider-trading scandal.

Long before the latest Pentagon investigation began, Congress was moving to curb abuses and spur competition in defense procurement. A turning point was the 1984 passage of the Competition in Contracting Act, which decreed that whenever possible the Pentagon should seek out at least two bidders on a project. Before that time, 57% of all private defense contracts were awarded with no competitive bidding. Now that figure is down to 14% of the 61,000 contracts approved by the Defense Department each day. Another crucial change in recent years has occurred in the way the Government pays for its weapons. In the past the Pentagon provided the predominant share of the development costs to the contractors. Now the companies must spend large sums of their own money up front to build planes or ships -- and risk losing that investment if the contract goes to a competitor.

The new procedures have made business much more treacherous for the Pentagon's suppliers. After General Electric spent millions developing the F- 404 engine for the F/A-18 jet fighter, Defense officials turned around and gave 30% of the contract to Pratt & Whitney. To make matters worse, the Pentagon forced GE to give Pratt & Whitney the necessary development and production technology. Bell Helicopter Textron and Boeing Helicopter have each laid out about $300 million to develop jointly a tilt-rotor aircraft for the Navy, Air Force and Marines. But once several of the planes have been tested, the companies will be competing for the lucrative contract to build the finished products.

In the contest to build the Navy's advanced tactical aircraft, a team headed by McDonnell Douglas and General Dynamics won out over a group that includes Northrop and Grumman. But Pentagon investigators are looking into allegations that McDonnell Douglas won the contract partly through bribery. If that turns out to be true, its team could lose out and the project would be put up for new bids.

As the Pentagon tries to trim costs, it is insisting that companies set a fixed price on research and development for many weapons systems even before they are off the drawing board. The notion draws flak from industry representatives. "Creating brand-new high-tech systems isn't like building a house," complains Don Fuqua, a former U.S. Representative from Florida who is now president of the 48-member Aerospace Industries Association. "Companies are being forced to bid a fixed price on something that's never been built before." In a 65-page report issued last summer, 13 defense-industry officials complained that the Pentagon's policy gives manufacturers "little incentive to take on projects that involve technological risk and innovation." New Mexico Democrat Jeff Bingaman has introduced a bill in the Senate to limit the use of such fixed-price contracts.

Critics of Pentagon waste hail the department's new rules for having helped curb the sort of skulduggery that used to allow contractors to sell the Government $7,000 coffeemakers and $600 toilet seats. They maintain that defense companies, far from destitute, are simply earning less than the bloated profits they once viewed as their birthright. Says Dina Rasor, director of the private Project on Military Procurement: "It's like taking a fifth hot-fudge sundae from a fat man, and he complains that you're starving him."

The industry as a whole is far from going broke. Overall profits are expected to rise about 4% this year, to $4.9 billion. But some companies are being hit much harder than others. Among those hurting are General Dynamics (the No. 2 defense supplier, with Government contract awards of $7 billion in fiscal 1987), Grumman (No. 10 with $3.4 billion) and Northrop (No. 23 with $1.1 billion).

General Dynamics has been squeezed by the rules requiring companies to put up more of their own money in the initial stages of Pentagon programs. The St. Louis-based firm has spent about $50 million to develop the advanced tactical aircraft, while its sales of submarines and tanks have been flat. Profits are expected to dip about 5% this year, to $415.2 million, and some analysts forecast a drop of 7% or more next year.

Grumman's woes began to surface last year, when the Bethpage, N.Y., company ran into a series of costly delays in its F-14 fighter program, caused mainly by the failure of subcontractors to deliver the planes' avionics systems on schedule. Grumman's 1987 profits dropped 55%, to $36 million. Now the company faces a new problem: Carlucci intends to end funding for Grumman's A6 Navy bomber, which accounted for 15% of last year's pretax profits. "If any company in defense is vulnerable, it is Grumman," says Paul Nisbet, an industry analyst with the Prudential-Bache investment firm.

Northrop is under attack on several fronts. The Air Force is complaining about shoddy workmanship in the Los Angeles company's Tacit Rainbow anti-enemy radar missile project, and the entire system, which could be worth an estimated $3 billion to the company, seems vulnerable to being cut from the Pentagon budget. Former Northrop employees charge the company with filing at least $400 million in questionable expense claims in connection with the development of its MX missile-guidance system. In addition, the Government is looking into allegations that the company bribed South Korean officials in the hope of boosting overseas sales of its F-20 fighter. The B-2 Stealth bomber is also being investigated for possible billing abuses, and could have its budget severely trimmed. Because Stealth accounts for nearly half the company's revenues, some analysts expect Northrop's profits to fall this year.

With the defense-industry slump expected to linger for at least the next few years, companies that have been hedging their bets by diversifying are likely to fare better than those that remain heavily dependent on a few projects. Loral has moved more aggressively into sales of the sophisticated defense electronics that have been relatively immune to budget cutting, while Lockheed is working on rocket motors for future space shuttles. But the companies that supply instruments of war to the nation's generals and admirals fear that the latest scandal will prompt a series of excessively restrictive new laws that will make it even more difficult to do business. "The wave is just now crashing on us," warns Norman Augustine, chairman of Martin Marietta. Just how much damage it does may depend on the defense industry's ability to trim its sails.

With reporting by Jerome Cramer/Washington / and Thomas McCarroll/New York