Chapter 26

The Big Explosion In Defense Industries

In the forefront of the defense industry is the aircraft-turned-missile business, now more popularly called the aerospace industry. The aerospace companies lean heavily on electronics, as a substantial portion of a defense dollar goes for electronic gear.

The Dramatic Shift in Defense Emphasis

The recent changeover in our nation's defense from manned aircraft to missiles has brought a far-reaching and fundamental change in the industry structure. This is evidenced by the grand entry of defense contractors into electronics or avionics. The following are just a few examples: the acquisition of Page Communication Engineers by Northrop Corp., of Norden-Ketay Corp. by United Aircraft Corp., of AMF's Associated Missile Products Co. division by Marquardt Corp., of Stromberg-Carlson by General Dynamics, of an 80 per cent interest in Fenske, Frederick 8c Miller by Temco Aircraft. Lockheed's electronics facility was built around Stavid Engineering, a New Jersey firm acquired in 1959.

The change in the structure of the defense industry is a fundamental one, most strikingly illustrated by Martin, an old-line aircraft maker, which completely abandoned plane-making in December 1960. Martin's facilities now are used exclusively for missile and space projects, including the production of the Titan intercontinental ballistic missile at its Denver division, of the Pershing and Bullpup missiles and the Missile Master (an electronic antiaircraft fire control system) at its Orlando, Florida, division, and of the Mace missile and an ICBM launcher for the Dyna-Soar boost-glide vehicle at its Baltimore home plant. Today, more than 40 per cent of Martin's engineers are engaged in electronics work.

With its changeover to missile-making, Martin increased its volume by more than $100 million between 1952 and 1960 while in the latter year it used 2 million fewer square feet of floor space. Along with other defense contractors, Martin expects a substantial increase in business due to nationwide concern over America's missile and space programs.

The Gateway to the Space Age

However, the industry's real, long-term future rests on its role as the gateway to the space age. Even if disarmament canceled U.S. defense contracts, as much or more business would subsequently develop for space projects.

America's expenditures for space activities should soar to $12 billion to $15 billion a year over the next decade. In January, 1962, the President announced that expenditures of the National Aeronautics and Space Administration, for example, would be budgeted for the fiscal year 1962-3 at more than double those for 1961-2.

There have been ever-increasing indications on the part of private industry for exploration and economic development of space without government contracts. Frederick R. Kappel, president of the giant American Telephone $c Telegraph, has announced that his company would seek to set up a worldwide communications systems using a space satellite. This was the first indication that an American company wants into space on a private-enterprise basis. He was followed by Ralph J. Cordiner, president of General Electric, who indicated his company's readiness to head spaceward on its own.

The Low Profits of Space Business

As of now, companies which have found commercial applications for space or missile components are rare. The principal benefits from current space projects, as far as most firms are concerned, is know-how that will be useful in future, and perhaps more profitable, space work. "If we ever have manned space flight on a commercial basis, some of these things we've done could pay off," T. G. Hawkins, treasurer of Garrett Corporation has observed. "But that's a long way off."

But Wall Street has been in the habit of looking at the future rather than at the past or present. It is earning potential, instead of realized earnings, that is given top market evaluation. That's why, for example, General Electric channeled most of its 1960 spending of $135 million (compared with $91 million in 1959) into such relatively new technologies as atomic energy, computers, space vehicles and related activities.

The world of space may be glamorous and exciting, but companies turning out rockets, satellites and related gear are by no means exactly profitable, at least not now.

"Sure, there's a lot of money going through the mill," a Douglas Aircraft Company executive was quoted by the Journal as saying, "but very little of it sticks to the paddle wheel."

The low level of space earnings is due to the high proportion of low-profit research and development work, as well as to short production runs. Since each missile or space vehicle is very nearly custom-made, the day of volume production is over. Also responsible for the shorter production runs are the rapid advance of technology, which renders equipment obsolete quickly, and the awesome power of modern weapons, which means fewer weapons. It's common knowledge that one doesn't make money by making only one to ten of an item. Nor can any line of business be very profitable until volume production develops.

Money in Manned Aircraft

The unpopular plane-making section of the missile makers is in much better shape than is generally realized, now that previous losses on commercial aircraft have been completely charged off. A sharp earnings rebound seems in prospect for plane manufacturers.

Even from a military point of view, plane-making still has a long and useful life. It was a U-2 accident that dramatized the effectiveness of manned aircraft. Since U-2 planes have been able to penetrate Russian air space for years, planes like the B-70 should be able to devastate Russia in case of a war. After all, a B-52 bomber, in the words of a "white paper" released by the Defense Department April 10, 1960, "can deliver many times the explosive potential of an Atlas ICBM, with greater accuracy and selectivity." The Pentagon's "white paper" also contended that America's bombers give her overwhelming superiority in total military strength.

Since manned aircraft are going to be in business for quite a while, there is still good money to be made delivering some manned aircraft. Grumman Aircraft Engineering Corporation, for example, is said to have contracts in hand for six military aircraft and one of their successors, plus a commercial airplane, which should maintain production, sales and earnings at healthy levels for the next four to five years.

Meanwhile, Grumman's work in the missile and space fields is increasing. Late in October 1960, for instance, the National Aeronautics and Space Administration selected Grumman to develop a l½-ton satellite to carry star-gazing telescopes into orbit.

Like Grumman, most aircraft companies are rapidly stepping into aerospace, of course, with different speed and emphasis. Undoubtedly, companies which are dependent upon comparatively few defense projects are bound to be more vulnerable.

The Strange Disparity in Defense Evaluations

Because of the usual uncertainties of military contracts, defense stocks have traditionally been accorded low price-earnings multiples. For instance, even with its business completely in the new military and space sciences, Martin is still selling for only 12 times earnings, compared with 30, 40, 50 or even more times earnings given stocks of some of the small science and electronics firms which are doing only subcontract work on military projects.

It doesn't make much sense for the market to evaluate "independent" electronics issues at 30, 40 or even more times earnings while evaluating electronics outfits of comparable quality at only ten or so times just because they are part of prime defense contractors. Most of the new glamour industries, such as infrared, microwave, and optics instrumentation, are tied directly or indirectly to defense.

Good examples of old-line aircraft companies doing super-glamorous work are McDonnell Aircraft's Mercury man-in-space project and Republic Aviation's new high-powered gun-welding process which may speed fabrication of space vehicles.

The Future of Aerospace Stocks

Aerospace must certainly be considered a growth industry at least for companies like Martin, which had advanced sales and earnings every year since 1951, or Garrett Corporation, whose whole story is one of growth. According to a study by Peter P. McDermott & Co., Garrett is "about the last word in precision engineering required in the production of components for missiles, spacecraft and aircraft. It produces nearly 2,000 important mechanical items, including full systems for pressure and temperature control, pressure-ratio transducers, analog electronic computers, which make it an active participant in 27 missile programs. The rapidity of Garrett's growth is shown by its sales of $14.2 million in 1948, $73.7 million in 1952, $103.4 million in 1956, and $224 million in 1960; or its earnings per share of $3.98 in 1958, $4.61 in 1959, and $5.42 in 1960.

If any industry has sure business, it is aerospace, which is basic to U.S. existence. Former Secretary of State Dean Acheson was quoted by Eldon A. Grimm of Walston & Co. as saying that the most vital issue facing the U.S. is that of survival. It is common  knowledge that for every dollar spent by the government, 56¢ goes for defense items. So, the future of defense contractors is less uncertain than is generally believed, especially in view of the fact that the defense budget appears to have a clearly defined upward trend, at least for the foreseeable future.

In his August 2, 1960, market letter, Eldon A. Grimm of Walston & Co. listed six "survival stocks" which he thought were basically wrapped up in defense. They are Republic Aviation, Garrett Corporation, Aerojet-General, Grumman Aircraft, Boeing, and the Martin Company.

Each of Mr. Grimm's six "survival stocks" undoubtedly has played a vital role in defense, though there is considerable room for disagreement as to their choices, compared with other important defense issues such as Lockheed, North American Aviation, General Dynamics, McDonnell and Northrop. With at least a few dozen missile and space projects either under development or in actual production, and with their relative importance changing all the time, no two security analysts are likely to come up with identical lists of what should constitute the half-dozen defense contractors whose programs are deemed most vital.

A safer approach to the problem appears to be one followed by Dean Witter & Co. in the adjacent list of major U.S. missile and space programs which are receiving the highest national priority.

This list of vital defense programs is, of course, subject to constant review by the Pentagon in the light of the changing weapon technology and the changing international situation. For instance, it was the collapse of the Paris summit conference that made the Pentagon accelerate the Samos satellite program for photographing enemy installations as a substitute for U-2 reconnaissance planes. Besides, the composition and fortunes of defense companies have undergone rapid change as a result of mergers and acquisitions among them.

The Weapons System Concept

Probably the most basic change in the operations of defense companies since World War II, according to an August 1960 appraisal of the defense industry by J. R. Williston & Beane, "is the development of the weapons system concept. This concept recognizes that the supporting and supplementary portions of a weapon are today quite as expensive and as complex as a single weapon of World War II. These supporting complexes include communications networks, launching sites, guidance systems, power plants and many others. The primary recipient of a contract now acts more as a coordinator and a leader of a group effort."

MAJOR U.S. MISSILE AND SPACE PROGRAMS

                                                Prime
Program           Mission            Contractor        Propulsion        Guidance
Atlas*              ICBM              Gen.                 No. American   American
Dynamics         Aviation            Bosch Anna
Titan*               ICBM              Martin              Aerojet Gen.    Gen. Motors
Polaris*            IRBM              Lockheed         Aerojet Gen.    Gen. Electric
Minute-            ICBM              Boeing              Aerojet Gen.    No. American
man*                                                                Thioko             Aviation
Pershing           IRBM              Martin              Thiokol             Bendix
Samos*            TV                   Lockheed         Atlas Missile        —
                        Satellite
Midas*             Infrared            Lockheed         Atlas Missile        —
                        Satellite
Mercury*         Space               McDonnell       Atlas Missile        —
                        Capsule
Saturn*            Super               No. American
                        Booster               Aviation

*Priority rating

However, prime contractors like Martin have been able to build complete missile systems including guidance and control as well as electronic equipment. The same is increasingly true of Lockheed Aircraft which has come to work in almost every field of physical sciences and technology. Whereas missile, satellite and space programs accounted for 39 per cent of its volume in 1959, the percentage rose to about 52 in 1960. Lockheed is the prime contractor of the Polaris missile and manufacturer of the only space vehicle now produced on an assembly-line basis.

Northrop Corporation also has strong capabilities in avionics and electronics., with over two thirds of its backlog now in electronics, missiles and space projects. Instead of depending on any single program for a major portion of its volume, it has laid great emphasis on systems-weapons, communications and control. North American Aviation is another fast-growing factor in aerospace. It holds the prime contracts on the B-70 supersonic bomber and Saturn superbooster programs. It is important both in liquid-and solid-propellant rockets.

Aerojet-General, 84 per cent owned by General Tire & Rubber, is the nation's largest manufacturer of missile power plants and liquid and solid fuel propellants. It is building rocket boosters and power plants for most major missile and space programs, including Titan, Minuteman, Genie, Bomarc, Polaris, Eagle, Sparrow III, Tartar, Hawk, Thor-Able, Scout and Delta. Since the company is active in both of the two major propellant fuels it appears to be in a strong position to withstand any possible shift in missile technology.

In the forefront of space technology is McDonnell Aircraft whose position has been strengthened by the successful launching of the first orbital flight for the Mercury man-in-space program. According to a recent Wall Street study, the program is one of the most complex and sophisticated projects yet undertaken by any company. McDonnell has the prime responsibility for designing the complex miniaturized systems, providing ground, automatic and manual controls, two-way communications as well as the system to provide the astronaut with environmental cockpit conditions comparable to military aircraft flying within the atmosphere.

Defense Electronics

An alternative to broad-scale participation in the defense industry is participation in the electronics end of its business which accounted for 51 per cent of total electronics sales in 1959, accentuating the importance of defense to the electronics industry. As missiles become more complicated, they require more elaborate electronic support. Furthermore, launching and ground-support equipment is becoming even more expensive than the big birds themselves.
 
Well situated in military electronics is Raytheon, a leader in microwave and power tubes. It is also important in antisubmarine warfare, along with Loral Electronics and a small company, Chesapeake Instrument.

RCA and International Telephone & Telegraph stand out in communications electronics. The former is the prime contractor of the ballistics-missile early-warning system. The latter produces equipment for the Strategic Air Command and for the tactical air navigation system. The two are working on a modernization plan for the Air Force's global communications system.

The following discussion is a sampling of specialty firms in military electronics.

Emerging as an expanding factor in military electronics is Standard Kollsman Industries which is the world's leader in automatic celestial navigation.

My attention was first drawn to Kollsman by William Lowitz of E. Lowitz & Co., a close follower of this company whose older-line TV-tuner business becomes overshadowed by its rapidly expanding military electronics, especially resulting from broadening usage of its celestial guidance equipment and airborne instrumentation.
Mr. Lowitz told me that he looked for considerable growth for business of this specialty defense electronics firm because of the sharply upward defense spending in the foreseeable future, particularly in the more sophisticated segments such as Kollsman's astroguidance instruments, which utilize the stars or sun to plot position and direction in navigation, as different from inertial guidance instruments that obtain position readings from a fixed inertial device. Believed to be more accurate under extreme flight conditions, the former is considered as the ideal navigational technique for future terrestrial and interplanetary flights.

A comparatively small but fast-growing factor in military electronics is Electronic Specialty which, instead of being a sick company with one product twelve years ago, has developed into a well-integrated operation of five major growth areas. Sales have grown at an average rate of 50 per cent annually.

All of its recent acquisitions are designed to develop the company into a complex with total systems capability. Its recent merger with D. S. Kennedy has firmly established it as a leading antenna manufacturer in addition to its strong foothold in communications, power generation and advanced weapons systems.

Pneumodynamics Corporation is interesting because of its being a fully integrated manufacturing, engineering and marketing defense contractor supplying components and services involving advanced technology to the missile and aircraft industries. "The philosophy," said Walter Untermeyer, Jr., of Laird, Bissell & Meeds in his June 1961 study, "of manufacturing and distributing organization adding scientific and engineering divisions to develop prototypes for its division's eventual production strikes us as an intelligent concept."

A growth situation in specialty military electronics is Statham Instruments which occupies a prominent position in analytical transducers, "the eyes and ears of electronic measurement and control systems." According to William Kurtz of Paine, Webber, Jackson & Curtis, Statham's growth rate has averaged 30 per cent per annum in the past, which rate is expected to be maintained over the next several years. The military transducer market is estimated at a yearly volume somewhat over $40 million.

Other well-situated issues, in specialty military electronics are Lear, Inc., a leading designer of aircraft and missile instrument products, electromechanical actuators, gyros, etc., and Avco Corporation which has emphasized its Cape Canaveral activities, notably its missile nose cones, and advanced research in aerospace, such as preliminary development studies on a plasma-jet electric rocket engine. A plasma is a combination of negatively charged electrons and positively charged ions in a kind of vapor. It is created when electrons are stripped from atoms. An advantage of a plasma motor is its small size and weight. The plasma studies are for a power plant that may carry man and equipment to the planets and back. Avco has been working with a small firm, Ail-American Engineering, on a braking mechanism to enable space vehicles to re-enter the earth's atmosphere. This device was successfully used in the Discoverer series satellites.

The Hazards of Defense Industry Investment

"Recommendations for stock purchases" said E. F. Hutton & Co., "are obliged to include explanations of the innate hazards involved, and contract renegotiation considerations deserve particular mention when discussing the defense industry. Congress has been highly critical of Pentagon procurement policies, especially on the use of negotiated instead of fixed-price contracts and, as a result, the renegotiations law has always been short-term legislation."

Consequently, defense contractors have been subject to the uncertainties of possible refunds, aggravated by the fact that sometimes the Renegotiation Board consumed a long time in determining excess profits. (Some recent actions date back to 1952.) North American Aviation, for instance, has been cleared by the Renegotiation Board for 1956 and 1957, but the Board has claimed excess profits were realized in 1953, 1954 and 1955 which could require refunds to the government of $1.3 million, $5.5 million and $3.5 million, respectively, after tax adjustments, if sustained by the tax court. The possibility of future refunds by North American Aviation and others, including Martin and Lockheed, should be recognized as one of the speculative aspects of the industry.

The industry, however, is hopeful of some favorable alterations in this practice, though its push for such alterations may lead, in the estimate of E. F. Hutton & Co., to "the tightening of policies in order to produce more accurate cost estimates from bidders and to reduce the possibility of tying up taxpayer's money, slated for the defense program, in drawn-out legal battles for excess profit refunds."

Marginal Weapons

Another hazard inherent in the defense industry is the rapid shift in weapon emphasis—there is such a thing as weapon obsolescence. In 1959, the Air Force had to drop its Goose decoy missile when the more advanced Quail (with the same aim of confusing enemy defenses) overtook it in development. "Our weapon plan is like a cornfield," said a Pentagon official. "We plant lots of seeds and later thin out those that aren't growing too well."

It is no secret that defense planners have, from time to time, examined what they call marginal weapons, especially those which would involve heavy spending in future years as they reach advanced stages of development. There is, of course, a limit to American resources. The country could not possibly produce every missile or space project it researches and develops. Right now, for instance, no fewer than twenty-five space projects and sixty missile programs are in various stages of development. To develop all at the pace demanded by their programmers would swell the defense budget to such an extent as to be destructive economically.

As shown, you must know something about the nation's actual defense planning to know which weapon is marginal, though the trouble is compounded by the fact that weapons ratings change from day to day. Worse still, most times, government planners fail to agree.

Take for instance North American Aviation's B-70 bomber. The B-70 is a high-altitude, long-range supersonic bomber, planned as a replacement for the B-58 which forms the backbone of the Strategic Air Command. While its Air Force backers hailed the weapon as the "hottest bomber ever conceived," former Budget Bureau Director Stans flatly called it "a tremendously expensive development." Its opponents further argued that it would fly too fast for accurate bombing. Another objection: the planes may be on duty too late to be of any use.

Should You Sell on Peace Talks?

To stay away from the makers of marginal weapons is one thing; to sell defense stocks at the height of peace talks is quite another.

"Never sell on strike," goes a Wall Street saying. The idea is that a strike is only temporary at worst; any sell-off due to a strike is almost certain to be canceled once the strike is out of the way.

It seems to me that the same can be said o£ peace or disarmament talks. The fellow who, in August 1959, sold Martin at 37-38 at the height of Khrushchev's "peace" talks was sure to miss the stock which came back strongly after the summit fiasco at Paris.

On August 10, 1959, the Dow-Jones Industrial Average dropped 14.78 points to close at 653.79 (it had been down more than that during the day), the sharpest break in nearly four years! Why? Because Khrushchev said he would go to Washington. The prospect of the Khrushchev visit and the possibility o£ reduction in defense spending brought about the break, though nobody actually expected any drastic military cut from Khrushchev's visit.

Nothing short of an iron-clad disarmament agreement with Russia would ever allow the U.S. to slacken its defense effort. And the prospect of reaching such a foolproof agreement is extremely dim. "Just finding out the basic facts and figures about the Soviet defense effort would be a staggering task," a top level Pentagon planner was quoted by The Wall Street Journal as saying. "Verifying these findings would be even more difficult."

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