A group presentation given at the end of my Econ 345 (Public Policy Towards Business) class at UNC

1. Courtney Youngblood and Jack Michel
1 December 2008
Economics 345 – Public Policy Towards Business

2. The industry is normally referred to as the Aerospace and Defense Industry to include
both firms dealing with aerospace and defense since the two fields rely incredibly
upon each other.
The aerospace industry produces aircraft, spacecraft, and their propulsion systems.
The defense industry produces land, air, and sea military vehicles, satellites, weapons, and
ammunition.
It is easy to see how these two overlap. Many of the companies within this industry
participate in both due to the similarity of production and the idea the defense
industry is considered recession proof. Boeing is an example of this.
For this project – the focus is on the defense sector only (excluding firms with a
primary focus on commercial aircraft [i.e. Boeing])
Very Lucrative Industry
The US Government planned to spend $480 billion on defense spending in 2008.
Total world defense spending was 1.2 trillion in 2006.
Very Important
Defense is a very important function of our government and country’s existence. The United
States spends almost 5% of its yearly GDP on defense.
Technological Playground
The Defense industry is one of the most technologically advanced industries. Research and
development is one of the common words found in this industry. Many technologies created for
the military eventually find their way into civilian use.

3. Historically, the defense industry is one of the oldest in existence, as arms have been
manufactured for profit throughout human history. Since even before Greek
Antiquity, blacksmiths and metalworkers have made swords, spears, and shields for
personal and military use.
As a result, the history of this industry is one of amazing depth.
Some major happenings
With the invention of gunpowder, arms making required more resources
and additional skills. As a result, specialized guns makers emerged.
Companies such as Colt (1847), Smith and Wesson (1855) are famous in
American history. Still, many governments kept arms production under their
control such as the British Royal Small Arms Factory and the United States
Springfield Armory.
Shipbuilding has always been a very resource intensive craft. In the
1500s, ship building firms began to appear that specialized in making ships.
Government assistance was usually always required.
The defense industry we see today really emerged in the beginning of the 20th
century with the need for and emergence of advanced weapons such as
aircraft, complex vessels, and armored vehicles.
Governments issued their needs and firms rushed to design a product to win the contract.

4. World War II
Massive war requiring full-scale industrial production for the war effort.
Many companies had successful products through contracts, but almost
all defense firms had business and were profitable. This was because
many projects, such as the B-17 Flying Fortress, were licensed to be
produced by whatever firm had production capacity.
Post World War II - Weapons Build-up
During the Cold War years (1945 to 1991), the United States and the
former Soviet Union engaged in a massive weapons build-up for both
political and strategic reasons. Defense budgets were at high levels.
Additionally, whenever the United States was at war, its defense
spending increased and defense contractors took advantage. The same
was true for countries to which defense contractors exported.
This was a prime time for the defense industry
Post Cold War
United States government changed its military doctrine
New Policy was to be able to conduct two major regional conflicts (comparable
to the 1991 Gulf War) simultaneously.
Trend of Market Consolidation

5. The Reasoning
After the Cold War, countries’ (the United States and Russia’s in
particular) defense budgets reduced dramatically. The defense
industry’s infrastructure would have to reduce by approximately 40% to
match this change in demand.
The Department of Defense hoped the mergers would decrease the
amount of overall assets (primarily physical) dedicated to defense. As a
result, the United States government was in full support of the push for
market consolidation.
As technology matures, a dominant design is established and there is
pressure for firms to consolidate as fewer product offerings exist in a
market
The initial reaction
Between 1993 and 1998, mergers and acquisitions occurred within the
defense industry at a rapid pace.
Companies such as Lockheed Martin (1994) and Northrop Grumman
(1995) resulted from major mergers.
Acquisitions were the most common. The major companies (the two
aforementioned, Boeing, Raytheon…) gathered up the smaller ones.

6. United States Government Opinion Changes in 1998
The US Department of Defense rejected the merger of Lockheed
Martin and Northrop Grumman along with General Dynamic’s
acquisition of Newport News Shipbuilding out of fear of lack of
competition.
This halted the industry’s trend toward market consolidation, as
the defense industry believed a mass consolidated industry was
what the government wanted.
The result of the consolidation trend
By 2000, it was clear that the consolidation trend had not
produced lessened assets and profits margins were reduced as
had been expected in the defense industry.
9/11/01
The terrorist attacks of 9/11 changed everything. The United
States military spending has increased greatly since this date.
Another market consolidation trend began recently (2003)
Larger companies are trying to avoid subcontracting and are
gathering up many of the smaller specialized companies.

9. Boom years for the arms industry, with
contracts for the top ten weapons contractors
up 75% in the first three years of the Bush
administration alone.
The biggest increases in defense spending since
Ronald Reagan.
Military budget increase coupled with ongoing
operations in Iraq and Afghanistan and the War
on Terror created an environment in which
weapons makers can enjoy the best of both
worlds.

10. These are the two firms of focus for this presentation
Lockheed Martin and Northrop Grumman are two of the
top four firms in the world’s Aerospace and Defense
Industry.
Both have their operations primarily in defense related
business and therefore are prime examples of top firms in
the defense industry.
Lockheed Martin receives 91% and Northrop Grumman receives
78.4% of revenue from defense related operations. For
comparison, Boeing (considered an aerospace company) does 50%.
2007 Rankings in the world’s Aerospace and Defense
Industry (chart later in slideshow)
Lockheed Martin #1
Northrop Grumman #4

11. Lockheed Martin resulted from a merger in 1995 between two
already successful firms: Lockheed and Martin Marietta
Lockheed Martin Marietta
Founded in 1926 by Alan Loughead. In 1929, Founded in 1961 by a merger
sold out to Detroit Aircraft Co., but company between The Martin Company and
failed during Great Depression. Re-emerged in
1934 under a new chairman, Robert Gross. American-Marietta Corporation
Won a contract for the P-38 Lightning, the The Martin Company was founded in
only U.S. aircraft produced throughout the 1912. It produced a successful
entirety of World War II. Very successful.
bomber design in WW I. Martin was
Secretly developed the U.S.’s first jet fighter
(P-80) in a secret program called “skunk
similar to Lockheed and found
works.” This program would produce many success in WW II aircraft production
top secret designs throughout the companies (B-26 Marauder)
history.
Focus in the 1980s was on
During Cold War, primarily produced spy
planes (U-2) and military transports. Many of rockets, missiles, structures, and
these transports were successfully used by vehicles for space missions.
civilian airlines.
Bribery scandal in 1970s in relation to
“guaranteed contracts.”

12. Headquartered in Bethesda, MD
Employs 140,000 people worldwide
Current CEO: Robert J. Stevens
World’s largest defense contractor by revenue.
Revenues of 41.862 billion in 2007
Operating profits of 4.527 billion
In 2007, 91% of all revenue came from the United States Department of
Defense, other U.S. government agencies, and military departments from
foreign governments.
Operations in aeronautics, electronic systems, information systems, and space
programs.
In 2001, Lockheed Martin won the contract for the F-35 Lightning II, which is an
enormous contract calling for 3,000 production units and $200 billion before any
export consideration.
Major Impending Dilemma
Washington Post reported in 2006 that within 10 years, 100,000 of the
company’s employees would be retiring.

13. Northrop Grumman resulted from a merger in 1994 between
two already successful firms: Northrop and Grumman
Aerospace
Northrop Grumman
Formed as Northrop Corporation in Founded in 1929 by Leroy Grumman.
1939 by Jack Northrop, an
Primarily an aircraft producer.
outstanding aeronautical engineer.
Found amazing success in WWII with
Won a contract for a radar equipped
its naval airplanes. Three major
night fighter in 1940. The resulting P-
contracts were accepted
61 Black Widow was a very
(F4F, F6F, TBF Avenger)
successful WWII aircraft.
Three more major successes with
Experimented with “Flying Wing”
the A6 Intruder and Apollo Lunar
designs
Module in 1960s and F14 Tomcat in
In 1970s, F-5 Fighter was an 1970s.
outstanding success, which
Products were so reliable that the
eventually led to creation of F-18
company became known as the
Hornet in cooperation with
“Grumman Iron Works.”
McDonnell Douglas

14. Headquartered in Los Angeles, CA
Employs 122,000 people worldwide
Current CEO: Ronald D. Sugar
World’s 4th largest defense contractor by revenue
The world’s largest producer of naval vessels
Revenues of 30.148 billion in 2007
Operating profits of 3.06 billion in 2007
Ranks #76 on the Fortune 500 list of industrial companies
Forbes Company of the Year in 2002 for its “master of the art of innovation.”
Operations in aeronautics, electronic systems, information systems (and
IT training), space programs, and shipbuilding.
Its Newport News Shipbuilding division is the producer of the United States Navy’s
super carriers.
Provides additional services for non-defense related purposes.
Northrop-Grumman is one of the largest suppliers of IT systems to the
United States federal and state government.
Organized into four main divisions:
Information and Services, Electronics, Aerospace, and Shipbuilding.
Each of these divisions operates fairly independent.

19. Total Revenue
The 100 largest defense contractors generated defense-related
revenues of $318 billion in 2006
Percentage of Exports (Origination)
United States (52% of non-US world’s arms transfer agreements in
2006), Russia (21%), and the United Kingdom (12%).
Growth
Historically, has not been strong and usually below average
Between 1994 and 2007, net income growth in Aerospace and Defense
was 12.5% compared to 14.6% in S&P 500. Growth picked up between
2002 and 2007 when it was 20.4% (33.3% S&P 500).

20. Competition over contracts
Highly resource intensive
Time
Financial Costs
Skills

21. Although there are more than 100 defense
suppliers in the world, the market is dominated
by a handful of companies.
Five out of the top six companies are United
States based
A large number of companies concentrate
primarily on defense, but many firms within the
defense industry are companies with only a
small percentage of resources dedicated to
defense.
Appears to be a firm saturated industry.

23. Competition within the industry was intense from post
World War II throughout the entirety of the cold war.
Competition was at its prime in the 1980s when
twenty or more firms were competing over most
defense contracts.
Today, competition is nowhere close to the 1980s level.
The market is dominated by the top firms and the US
government usually resorts to using the same six
contractors for all defense needs.

24. High Resource Costs
Regulation
Contract System
Loyalty of customer (government)
Dominance of Market by large firms
Consolidation trend
Resources availability
Loyalty (again)

25. Resource Costs
Time
Financial
Complex products working with brand new technologies
are incredibly expensive.
Consolidation has resulted in reduced transaction costs
Risks of going over contracts

26. Firms within the defense industry cooperate together
on many projects
It is difficult for one company to be able to produce all of the materials
and systems that go into today’s complex military devices.
A contract will be usually be awarded to a prime contractor who will
then subcontract out many of the smaller tasks on the project.
One firm will produce the airframe and avionics. Another the
engines. A third will add the electronic systems and so on.
Usually the larger companies (ex. Lockheed Martin, Boeing) serve as
the prime contractor and the smaller companies (ex. Honeywell) do
the subcontracted tasks.
However, many of the larger companies continue to acquire
many of the smaller and niche companies in order to avoid
subcontracting.

27. The Defense Industry is a contract based
economic system.
All contracts given to the highest quality
at the lowest bidder.
Two contract types:
Cost-reimbursement (cost-plus)
contracts
Fixed-price contracts

28. Funding (in Weapons Systems Primary Contractors
billions of
dollars)
8.7 Missile defense
6.5 12 F-35 Joint Strike Fighter Jets Lockheed Martin Corp.
4.4 20 F/A-22 Raptor fighter jets Lockheed Martin
3.5 DDG-1000 Zumwalt destroyer program Northrop Grumman Corp. and General Dynamics Corp.
3.4 CVN-21 carrier replacement program Northrop Grumman
3.4 future combat systems program Boeing and Science Applications International Corp., or
SAIC
3.4 one SSN-774 Virginia-class submarine General Dynamics
2.6 26 V-22 Osprey tilt-rotor aircraft Boeing and Textron Inc.
2.1 24 F/A-18E/F Super Hornet fighter jets Boeing
1.6 18 EA-18G radar jamming aircraft Boeing
15 LPD-17 San Antonio-class amphibious assault ship Northrop Grumman

29. The Defense Industry is highly regulated:
Contract System
Defense Federal Acquisition Regulations
Supplement
Profit controls to cost allocation and
reimbursement issues.
Government inspectors, auditors, and technical
specialists typically oversee contract administration
and cost accounting practices.

30. No real substitutes exist
Product Substitution:
Nonexistent – Companies must defend themselves and they must
use weapons
One choice
Upgrade or buy new
No firm substitution
Weapons contractors are the only firms able to supply weapons at
the quality needed.
“Defense firms sell unique products in a
monospony where the only buyer is the United
States Government.”
Largely inelastic
Constant demand on industry due to defense needs; demand does not
change based on price changes. Contract system regulates price.

31. Further Consolidation
The top 10 firms in the defense industry should continue to acquire smaller
defense companies as has been the trend.
Increased Profits and Revenues
Demand expected to stay constant or increase with the ever looming fear of
terrorism, the needs created by two ongoing wars in Afghanistan and Iraq, and
the potential for world conflict.
Need to replace aging military equipment
Complications with the new administration
Pullout from Iraq? This would certainly reduce the supplemental funding
toward the United States defense budget.
Change of product priority
Focus on electronics, information technology, and unmanned weapons
US Defense policy is changing military’s tactics to emphasize these products.
Increased exports for US firms
US government has begun to purchase more from international firms (13.5
billion in 2005 to 16.9 billion in 2006)
Developing countries will need defense products as their wealth and military
threat levels rise

32. Military Spending Increase:
Replace aging equipment
Replace and repair equipment used in war
Upgrade the capabilities of our soldiers
Long term significant military threats
Budget Pressures:
Balanced budget
Entitlement Spending Competition
Declining Economy
Effects of Democratic control of Congress and Presidency:
Iraq War pullout
Social Program Funding
Aging Equipment

33. Average Return on Investment
Firm’s profits are similar to the market average
Average Growth
Recession Proof?