2 Top Defense Firms Could Fail, Pentagon Audits Hold

Pentagon audits have concluded that McDonnell Douglas Corp. and General Dynamics Corp., the nation’s two largest defense firms, have fallen into “weak” financial condition; each was rated by one analytical measure as having a “possible chance for bankruptcy.”

Although the prospect that bankruptcy could be looming for one or both of the contractors has been quietly debated in defense circles since early this year, the two audits mark the first time that an official government report has given credence to the possibility.

Auditors reviewed the financial conditions of the two firms in connection with a review of payments on the controversial A-12 attack jet program. The audits found that the two firms were overpaid for their work on the jet and recommended that the government seek unspecified refunds.

The audits, performed in September by the Defense Contract Audit Agency--the Pentagon’s accountants--found that the two firms’ financial conditions have deteriorated markedly this year.

But the audits did not find the firms’ ability to perform their contracts to be endangered, and the conclusions about possible bankruptcy were disputed by McDonnell and by Wall Street analysts. General Dynamics executives had not seen the audit of their firm and refused to comment.

Still, the Pentagon finding that the nation’s two largest weapons producers face the possibility of bankruptcy raises serious questions about the state of the nation’s defense sector, especially with a potential war looming in the Middle East, according to congressional sources.

The bleak findings about the two firms’ financial conditions reflect warnings sounded early this year by Rep. John D. Dingell (D-Mich.), who said cost overruns on their programs could lead to a demand for multibillion-dollar bailouts. “The bottom line is that the money is not there for a bailout,” a congressional staff member said Monday.

McDonnell Douglas and General Dynamics, both headquartered in St. Louis, are responsible for the most important weapons used by the Army, Navy and Air Force. They are jointly developing the controversial new A-12 Navy attack jet.

A General Dynamics spokesman said he had not seen the audit and could not comment directly on it. He added: “It is unfortunate that matters related to that were leaked at this particular time.”

McDonnell executives stood by earlier statements that discounted any possibility of a bankruptcy or a financial crisis at the firm. In a statement last week, Herbert Lanese, McDonnell’s chief financial officer, termed “ludicrous” any prediction of bankruptcy.

Also, the company belittled the calculations on which the audit agency based its assessment of the likelihood that the defense firms could fall into bankruptcy. A McDonnell spokesman said: “There is no formula in the world capable of predicting future performances of businesses.”

He was referring to the analytical method, known as a “z-score,” used by the agency. The score is based on a weighted average of five financial ratios that consider sales, operating profits, retained earnings and working capital as a percentage of total assets and market value of stock as a percentage of total debt.

The auditors gave McDonnell a z-score of 2.27, rating the company as having a “possible chance of bankruptcy.” At a score of 1.8 or lower, the firm would be given a “probable chance of bankruptcy.”

The most recent known audit of General Dynamics gave that firm a z-score of 2.42, also rating it a “possible chance of bankruptcy.”

In addition to the z-score, the audits reviewed a number of the financial problems facing each firm. And the audits examined several financial ratios of the firms’ debt loads. In McDonnell’s case, for example, its ratio of total debt to net worth has deteriorated since 1986. So has its z-score.

Private experts were skeptical of the Pentagon findings.

Said aerospace analyst Howard Rubel of C. J. Lawrence, Morgan Grenfell: “If I had to rely on the government for my financial analysis, I would be in a lot of trouble. One of the problems that exists in any form of government second-guessing is that they don’t understand what they are doing.”

He said that, although both companies face financial problems, neither has a solvency problem. Both, Rubel said, are expected to report good earnings in the current financial quarter.

Another expert, a commercial banker, said in a recent interview that a $750-million loan agreement announced just last week was a “vote of confidence” in McDonnell by the major national banks. “You don’t round up this kind of money today if you have undue risk,” he said.

But a bankruptcy analyst at a Wall Street firm that specializes in troubled companies said: “It looks like McDonnell has the capacity to blow up. It all depends on what the government does.”

Much of the confidence about McDonnell is based on the presumption that the Defense Department could not afford to bankrupt its largest contractor. Eventually, many analysts figure, some sort of relief on troubled contracts must be granted.

The two most worrisome of McDonnell’s programs are its C-17 cargo jet, which is facing an overrun on its contract ceiling of $600 million, and the A-12 attack jet, facing an overrun of more than $500 million on McDonnell’s share of the contract.

Similarly, General Dynamics is up against a $500-million overrun on its part of the A-12 contract.

THE BIGGEST DEFENSE CONTRACTORS’ BIGGEST PROGRAMS

McDONNELL DOUGLAS Aircraft F-15, F-18, AV-8B, A-12, T-45 trainer, ATF, C-17 Submarines None Land weapons None Helicopters Apache Rocket boosters Delta Missiles Tomahawk, Harpoon Civilian aircraft MD-80, MD-11

GENERAL DYNAMICS Aircraft F-16, A-12, ATF Submarines Trident, Sea Wolf, Los Angeles- class attack sub Land weapons M-1 tank Helicopters None Rocket boosters Atlas Missiles Tomahawk, Standard, Sparrow, Stinger Civilian aircraft Cessna