Washington Post Indicts Military-Industrial Complex

You've got to hand it to the newspaper industry. For a business that's supposedly in decline and fast approaching obsolescence, these guys continue to prove themselves invaluable day after day.

Yesterday
Take yesterday, for instance, when paper-of-record The Washington Post reported that the U.S. Navy is gearing up to reoffer contracts to build its new Littoral Combat Ship (LCS). And who got the coveted invites to rebid, you ask? Raytheon (NYSE: RTN  ) , perhaps, which lost out in the first round of bidding? Or maybe Northrop Grumman's (NYSE: NOC  ) Newport News Shipyard, birthplace of the nation's biggest aircraft carriers?

Nope. General Dynamics (NYSE: GD  ) and Lockheed Martin (NYSE: LMT  ) . The same General Dynamics and Lockheed Martin who had their original contracts canceled by the Defense Department when they massively overran their estimates on their respective previous LCS projects. According to the Post, the DoD hopes to convince the contractors to hew closer to their new estimates this time around, thanks to:

  • Congress upping the ceiling on what it's willing to pay per LCS, to $460 million; and
  • Sweetening the pot -- the best bidder gets to build two of the new boats, while the other guy has to be satisfied with just one. (Albeit, with the Navy planning to eventually float 55 of the craft, it's a safe bet that both companies will eventually get their fair share of the pie.)

Monday
All of which becomes even more interesting in light of another story reported in the Post earlier this week. Citing a report out of the Government Accountability Office Monday, the Post described how among contracts performed by the nation's major defense contractors, "95 major systems have exceeded their original budgets by a total of $295 billion, bringing their total cost to $1.6 trillion, and are delivered almost two years late on average."

Digging deeper into the GAO's 205-page report, the Post advises that the average defense program in 2007 cost taxpayers 26% more than initially estimated and was delivered 21 months late. Examining a few high-profile projects, the GAO noted that the first two LCS models will eventually cost more than twice their initially estimated $472 million. Less expensive, but still pricey, are Lockheed's Joint Strike Fighter (36% over budget) and Boeing's (NYSE: BA  ) Future Combat Systems (40% more.) A couple lower-profile Boeing blowouts cost taxpayers as much as triple their original estimates.

Ouch
Ouch, indeed. Now to be fair, General D and its brothers-in-arms-manufacturing don't carry all the blame for these problems. There's more than enough blame to share with the military that doles out the contracts in the first place. Blame for:                                               

  • Asking defense contractors to develop weapons systems utilizing technologies that don't yet exist, which seems guaranteed to produce inaccurate estimates in the bidding.
  • Moving the goalposts forward, backwards, and sideways over the course of a contract's execution. With billions of taxpayer dollars to play with, U.S. generals act like kids set loose in a candy store with Daddy's AmEx card and told to buy whatever they want. After initially asking for one thing, the military peppers its contractors with requests for upgrades and modifications as a project progresses -- forcing defense contractors to stop, reverse work they've already done, do new work and ... incur additional costs.
  • And finally, let's also not forget that the military deserves blame for accepting bids at face value, then awarding contracts to the very companies that GAO tells us have been off on their estimates by orders of magnitude in the past.

Foolish takeaway
Now that I've had my say from the overtaxed taxpayer's perspective, allow me to clamber off my soapbox and view this from a ground-level investor's point of view. The view from down here, I must say, looks mighty profitable.

Decades' worth of consolidation in the military-industrial complex has left us with an exceedingly sparse field of firms big enough, and technologically proficient enough, to take on the projects the Pentagon needs done. The fact that the Navy turned around this week and begged the same two firms, who failed to control costs on the LCS program a few months ago, to give it another try illustrates the situation perfectly: There's a lot of defense work to be done and precious few companies to choose from to do it.

Now throw in the fact that, wolf-like, these firms hunt in packs. A Lockheed, or a Boeing, or an SAIC (NYSE: SAI  ) will play lead contractor, then dole out subcontracts to the rest of the industry. Even when you hire, say, an aerospace firm like Lockheed, or a tank-maker like General D to build a boat, they just turn around and subcontract much of the work out to Manitowoc's (NYSE: MTW  ) Bollinger Shipyards, or Northrop's Newport News. In the end, everybody gets a piece of the work, and the contracts pay out on a "cost-plus-profit" basis.

For an investor in a defense contractor, you can't get much closer to guaranteed profits than this.


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