Change in Europe Clouds Defense Industry Outlook

The already grim outlook for Southern California’s defense industry is getting darker by the day amid Bush Administration budget-cutting and public enthusiasm for the fast-paced reforms in Eastern Europe.

After Defense Secretary Dick Cheney raised the prospect over the weekend that future Pentagon spending might be cut by $180 billion over three years, investors reflected the widespread pessimism for the industry’s prospects by sending stocks of defense firms sharply lower.

Share prices of many prime contractors--including Litton Industries, Lockheed, General Dynamics, Martin Marietta and Raytheon--fell by as much as 10%. Stocks of other local defense contractors, including Rockwell International and Northrop, also fell.

Defense firms already have more production capacity than needed for programs under way or in sight. Cheney’s comments indicate that an industry consolidation--including mergers, layoffs and even possible plant closings--is likely to be worse than previously expected.

The cutbacks suggested this weekend by Cheney included few details about how defense procurement would be affected, much less any specific programs. But the remarks reinforced the view that a protracted and potentially sharp decline in defense budgets is inevitable.

“Even without the cuts that have come into discussion in the last few days, we have too many aircraft plants and too much defense industrial capacity for the business available,” said Thomas L. McNaugher, a defense expert at the Brookings Institution. “The mere fact that the defense budget is coming down will force a substantial reduction in the industry. These newer cuts will just hurry along the process.”

“Just from a pure psychological point of view, things couldn’t be worse,” said aerospace analyst Jack Modzelewski of Paine Webber. “These stocks are significantly overvalued in a declining defense environment.”

Over the last week as East Germans began to freely cross the Berlin Wall, many defense stocks have lost 20% of their value. The upcoming summit meeting between President Bush and Soviet President Mikhail S. Gorbachev is fueling further anxiety among defense companies and employees that additional arms limitations will be in store. The prospect of wholesale downsizing of the defense establishment has generated critical economic questions.

Ripple Effect Seen

“You can’t just flick a switch and turn the industry off,” said Robert Costello, former undersecretary of defense for acquisition and now an analyst at the Hudson Institute. “It would have unusual and catastrophic ripple effects throughout the economy.”

Indeed, nowhere would that be more true than on the West Coast, where 40.3% of all aerospace industrial activity is based. At risk in Southern California are several hundred thousand defense jobs that have provided an underpinning for economic development since World War II.

A scientist at Hughes Aircraft recently was attempting to decide whether his future was more secure at his current job or at TRW or Northrop. “I don’t want to jump from one fire into another, but there is a real sense at Hughes that we are going to be facing more cutbacks,” he said. “I don’t want to be here when they occur, but I certainly don’t want to be at another company if they get cut.”

The possible $180-billion reduction would translate into a 6% decline annually. To comply with the reductions, the Air Force has proposed cutting 15 bases worldwide, trimming F-16 production in Ft. Worth, Tex., and further stretching out the B-2 Stealth bomber program.

Such a stretch on the B-2 program, which has already been delayed, would have a measurable affect on prime contractor Northrop, which depends on the program for about one-half of its sales.

The looming defense cutbacks will be ameliorated in the Los Angeles area to a large extent by the record backlog of commercial aircraft orders at McDonnell Douglas and Boeing. Douglas’ plant in Long Beach alone has an estimated commercial-aircraft backlog of $70 billion, including orders and options that will carry production past the year 2000. Moreover, the Los Angeles area is the largest aircraft subcontracting center in the nation.

Another major offsetting factor is likely to be growth in the nation’s civilian space budget. If the government wants to preserve some of its aerospace industry base, substituting civilian space programs for military ones can help keep capacity in place for later needs.

“They are growing the NASA (National Aeronautics and Space Administration) budget faster than any other part of the federal government,” said Paul Nisbet of Prudential-Bache Securities. “That and the commercial aircraft production is going to give the aerospace industry its biggest sales year in history this year--$130 billion.”

One major question hanging over the entire aerospace industry is whether research and development spending will be cut along with production. In fiscal 1989, Pentagon research amounted to $37.5 billion, contrasted to $79.6 billion for procurement. If research spending is kept level or even increased, a substantial amount of industry capability will be preserved.

“If they cut research and development, it will have a major impact on Southern California,” said Mohindar S. Sandhu, president of SRS Technologies, a Newport Beach defense engineering and research company. “The question is really where they are going to cut.”

Although the company has been trying to convert to commercial work, SRS is dependent on military contracts for 90% of its sales. “We are all nervous,” Sandhu said.

Experts are hoping that any reductions in the defense procurement system will be rational and logical, but they acknowledge that the downsizing will be a long political power struggle, pitting companies and geographic regions against each other.

‘Like a Poker Game’

“No one is in control,” said Modzelewski, the securities analyst. “It is like a poker game. Everybody will want something.”

As the defense industry approaches its difficult future, it is unfortunately not in good financial health. Even though the industry enjoyed the longest peacetime military buildup in history during the Reagan Administration, it has quadrupled its debt. In many cases, companies are already losing money and the worst is yet to come.

“The toughest job we face today is the restructuring of the defense industry,” the Hudson Institute’s Costello said. “A lot of people in the Defense Department and industry think that things will go along as normal. But things are rapidly changing.”

Although a downturn of some sort appears inevitable, some analysts believe it is far from clear just how severe the downturn will be.

“I think what we are seeing is an overreaction,” said Nisbet, the Prudential-Bache analyst. “Cheney hasn’t committed to anything.”

Nisbet noted that the $180 billion in proposed cutbacks would come off unrealistically high projections of future defense spending. Moreover, the $180 billion would be spread over a three-year period and could be offset to a large extent by future inflation assumptions.

“Nothing that has happened will affect this year’s earnings or next year’s earnings or even 1991 earnings,” he said. “The earliest that anything is affected is 1992 and a lot can happen by then.”

The changes in Eastern Europe, although greeted with euphoria today, are potentially dangerous because they show that Gorbachev has lost political control, Nisbet said. “What is unfolding today isn’t what Gorbachev had in mind with perestroika and glasnost six months ago,” he added.

“I can guarantee you that any reverse of the present environment that causes us to reassess cutting the defense budget will create an upturn in these stocks that even exceeds the downturn we are now experiencing,” Nisbet said. He has issued buy recommendations for a number of contractors.

A number of securities analysts agreed that the market is overreacting and questioned whether the possible cutbacks involve political posturing more than substantive planning.

“It is a question of investors shooting first and asking questions later,” said Howard Rubel of the investment firm of C.J. Lawrence, Morgan Grenfell. “We haven’t signed any agreements. All that has happened was that Cheney took an astute political posture for what may or may not happen. A cut of $180 billion in 1992 through 1994 is a long way off.”

Times staff writer David Olmos in Orange County contributed to this story.

IS KEY--Next month’s summit will help shape the next U.S. defense budget. A6