The Peace Deficit
The future of the aerospace industry lies in information technology and professional services
Fundamental shift. Paradigm change. A new world.
Call it what you will, but the aerospace industry has undergone a dramatic change of heart about information technology and professional services -- and that change has permanently realigned the balance of power in the defense business.
Long considered the dirty work of building and designing systems, IT, as it is known, and not manufacturing has become the central task in building systems that kill or fly. Why? Partly because computer hardware and software control all the basic functions -- and increasingly eat up the lion's share of contract money.
But a dramatic decline in orders for hardware also has forced those intent on surviving the ongoing consolidation to shift their focus and resources from manufacturing to software, maintenance and related electronics -- the guts of the weapons systems that really make planes, tanks and ships potent killers. That realization is driving the relentless consolidation in the aerospace industry, say analysts, insiders and observers.
So when Lockheed and Martin Marietta announced their intent to merge, it was no accident the combination created a company that will be the largest professional and technical services provider in the defense industry. And the combined $23.5 billion firm rivals even honchos like EDS and Computer Sciences Corp. in its ability to design, build and integrate complex computer systems.
Lockheed Martin told the industry they are determined to be survivors -- with Martin playing up its expertise in information systems, professional services and systems integration. Some smaller companies have used acquisitions to make a similar push.
McDonnell Douglas, by virtue of recent cost-cutting and its status as the largest prime, will likely be a survivor -- although as of press time it had yet to issue an official response to the Martin/Lockheed combination.
"We're under no pressure to buy anybody, and nobody's going to buy us," said a company representative at the Farnborough Air Show, noting the company, unlike Lockheed Martin, is focused mostly on hardware. He also noted expectations of consolidation have pushed up asking prices -- and could actually slow down consolidation in the near term.
Apply the same logic to the Sept. 13 GM Hughes Electronics decision to close a California manufacturing plant and lay off 4,000 employees. Media coverage after the announcement made little of a coincident shift of resources and prestige to the firm's Washington, D.C.-based operations, which focus on systems integration and information technology.
Henceforth, Hughes Aerospace and Electronics will be headquartered in Washington, D.C., and from here the company will focus on building its information technology and systems integration business -- as well as hunting for acquisitions to aid the effort.
Boeing, too, has joined this effort, establishing the Washington, D.C., area as base of operations for Boeing Information Services Inc. -- and letting it be known it has a war chest of money for acquisitions to help build the business.
And last year, Loral added momentum to this trend with its $1.5 billion acquisition of IBM Federal Systems -- which happens to be a prime contractor for the U.K.'s Merlin Helicopter program, even though it does no airframe manufacturing.
What's causing this shift? "Economics drives business combinations," said Doug Schmidt, vice president of Ferris Baker Watts, a Washington-Baltimore-based investment banking firm. And with a downturn in orders for hardware, shareholders of companies have realized that money invested in manufacturing plants provides an insufficient return on invested capital.
Simultaneously, they have discovered that return on capital invested in engineering and in people needed for professional services and systems integration is higher. As many aerospace companies have dabbled in these businesses at one point or another, the leap to being those kinds of businesses is, in theory, not so great.
Even more, expertise in information technology and professional services is also transferrable to new, non-defense lines of business - new air traffic control systems, computers for the IRS, or emergency dispatch for the local fire department.
What is one of the only growing segments of business for $2 billion, Dallas-based E-Systems, which traditionally depends on providing spy plane and satellite electronics? Its aircraft maintenance business.
The equation is simple: What can an F-15 do but fly and fight? But remove its systems and software, tweak a little, and you have enough simulators, automators, control systems to automate a small city, if not a smart highway or two.
But turning that logic into revenue is no small feat. Westinghouse Electronic Systems once could afford to incorporate concepts such as technology transfer and diversification into strategic plans as the company lived off contract backlogs. But a time of reckoning with the Darwinian realities of the present has come, as backlogs run out and cost-cutting opportunities dwindle.
The 1993 financial results of E-Systems, a provider of communications technology and electronics to the spy community, are telling -- and reflect a more general trend among aerospace companies. Total sales for 1992 and 1993 were essentially flat at $2 billion. But contract backlog -- which provides sales in later years -- has declined from $2.5 billion in 1991 to $2.1 billion in 1993. The firm is living off business won in previous years, with little indication it is replacing that business.
In its annual report, the contractor claims the number and diversity of future wars will force generals to rely more on intelligence and related technologies -- the firm's bailiwick. But from 1992 to 1993, the intelligence part of E-Systems' business actually declined, from $1.4 billion in backlog to $1.1 billion.
To be fair, the company has made efforts to step into new markets -- taking mass storage systems or computer security systems developed for intelligence agencies into commercial markets, for instance.
Obviously, the shift in importance from airframes to the systems that run them has not come without conflict. Talk to aerospace executives privately, and they acknowledge a rift between the manufacturing plant and the information technology and professional services side of the company.
For decades, manufacturers controlled and dominated corporate culture. There was no glory in programming or maintaining existing systems -- and in many cases this work was farmed out to lowly professional services contractors around the Beltway. Thus the manufacturing operations got the resources, time and nurturing now shifting, in many companies, to IT and professional services.
The Hughes announcement, said one knowledgeable executive, really represents the culmination of an internal struggle that has unseated the primacy of manufacturing.
The recent Farnborough air show in the U.K. dispelled any doubt about the validity of this trend. Booths from companies such as Rockwell, Northrop Grumman, Lockheed, Martin Marietta, E-Systems -- name a major defense contractor -- all touted expertise in systems integration.
For the first time in its history, Computer Sciences Corp. took out a booth at the show, calling itself the aerospace IT partner -- and for good reason. Last year it signed a $1.5 billion, 10-year contract to provide information technology services to British Aerospace.
The impact of this trend has been to raise the attractiveness of systems integrators and professional services firms around Washington, D.C. These companies have worked for decades in the shadow of aerospace prime contractors. They have done what was considered dirty work -- and what now is literally becoming the real business of aerospace.
At Farnborough, for instance, the Russians expressed their willingness to sell just about any kind of plane they manufacture. But there are few takers, because the electronics-related integration and software for these planes are so poor. "It's the computers that make these systems lethal," said Schmidt.
So the balance of forces has changed dramatically. CSC spokesman John Gulick said the shift has and will continue to be a boon for his company -- and for the many others in the industry able to spot and exploit the trend.
Dyncorp, a $1 billion professional services firm in Reston, Va., has purchased 10 companies since 1991, most in information technology. "We're looking for more acquisitions. That is not a secret," said Dan Bannister, Dyncorp president and CEO.
Boeing Information Services, in a recent story in WT, announced a similar intention. The unit aims to build a $1 billion information technology company in five years, and will probably need to acquire companies with revenues of about $250 million to get there.
This shift in the aerospace business therefore means continued acquisitions -- and plenty of business for investment bankers arranging the deals.
Ferris Baker was perhaps the first investment banking firm to spot the trend and get a piece of the action. A year ago, it began following professional services and information technology firms around the Beltway, figuring the market would soon realize the value of these companies. That bet appears to have paid off.