Lockheed Martin girds for battle

November 29, 2011: 5:00 AM ET

After the debt supercommittee's failure, defense contractors are preparing for turbulent times. Can Lockheed save the F-35 Joint Strike Fighter?

By Marc Gunther, contributor

FORTUNE -- Perilous times await Lockheed Martin, the world's largest military contractor. Wars in Iraq and Afghanistan are winding down. Because the congressional supercommittee failed to agree on a plan to curb the federal deficit, the Pentagon faces spending reductions that could add up to about $1 trillion over the next decade. One likely target: Lockheed's controversial F-35 Joint Strike Fighter, the most expensive weapons program in history.

Robert J. "Bob" Stevens, Lockheed's CEO, can't be happy about any of this, but the 59-year-old ex-Marine is not the complaining type. A tall, trim, bespectacled man of sober mien who chooses his words carefully, Stevens will say only that important decisions about national security should not be "a function of automatic budget triggers." Further spending reductions "would have a significant impact" on military readiness, the company says. Defense Secretary Leon Panetta has sounded an alarm of his own, warning "the impacts of these cuts would be devastating." If they are allowed to stand, he says, the military will be "forced to terminate most large procurement programs," including the F-35.

Thus is the stage set for yet another Washington budget battle. A great deal is at stake of Lockheed. The company will fight to protect its weaponry, particularly the F-35, which accounts for 13% of its revenue this year and is expected to grow in importance to the firm. "It's going to be a very challenging time for Lockheed," says William Hartung, an industry analyst and the author of Prophets of War: Lockheed Martin and the Making of the Military-Industrial Complex (Nation Books, 2011).

For his part, Stevens has been preparing Lockheed for the turbulence ahead. First, he has been reducing costs and eliminating jobs to turn Lockheed into a leaner operation. The company has sold businesses (most recently an architectural and engineering firm), closed factories (a communications facility in Eagan, Minn.), provided buyouts to 600 executives (a 26% reduction in the ranks of top management), and shed 20,000 jobs since 2009. "The worst thing I do is tell good people, 'I don't have a job for you,'" Stevens says. He isn't finished yet. Painful as it is, he says, reducing costs "is going to be a continuous focus over a long period of time."

Second, Stevens tells anyone who will listen that the world remains a dangerous place, citing the threats from Iran, Pakistan, and North Korea, continuing instability in the Middle East and North Africa, potential conflicts over resources with China—the list goes on and on. He believes that demand will grow for the weapons his company builds, not just from the U.S. government but from emerging markets like India, Brazil, and the Middle East. Lockheed recently agreed to sell 18 new F-16 fighter jets to Iraq, for about $3 billion. "We're working hard on the international front," Stevens says.

Third, the company has diversified to deliver a range of products and services to other government customers, including NASA, the CIA, the FBI, and the Department of Energy. NASA's Mars rover spacecraft, for example, which was launched on an eight-month journey to Mars on Thanksgiving weekend, is encapsulated and protected by an aeroshell that was designed and built by Lockheed. The company also supplies more information technology to the government than IBM (IBM), Microsoft (MSFT), or anyone else. Its hardware and software sort mail for the Postal Service, tally taxes for the IRS, and manage data for the Census Bureau.

lockheed martinDespite all that, Lockheed (LMT) remains closely tied to the Pentagon. About 60% of the company's sales this year will come from the Department of Defense, which buys cargo planes, fighter jets, advanced drones, spy satellites, and combat ships from Lockheed. Because of the wars in Iraq and Afghanistan, as well as the threat of terrorism, Pentagon spending has doubled since Sept. 11, 2001. It has grown in real terms for an unprecedented 13 years, even under President Obama, who, you may recall, ran for office as an antiwar candidate.

Not surprisingly Lockheed (based in Bethesda, Md., and No. 52 on the Fortune 500) has thrived during the Bush II and Obama years. Since Stevens was named CEO in 2004, revenue has grown by 30%, net earnings are up by 130%, and the company's stock price has grown by 40%; by comparison, the S&P stock index is up by just 8%. In 2010, Lockheed had record revenue of $45.8 billion, operating profit of $4.1 billion, and net earnings of $2.9 billion. Sales are up slightly this year, and they are expected to be "flattish" in 2012, the company says. Beyond that, it comes down to politics.

"In the absence of a Republican sweep in the 2012 elections, this is going to be a bad few years for the defense industry," says Loren Thompson, a defense analyst with the Lexington Institute, a Washington, D.C., think tank. "The things that are politically easiest to cut go first, and that means weapons." Tom Captain, the vice chairman of Deloitte and its global Aerospace & Defense leader, predicts that defense spending will be "flat to declining in the next few years."

Spending cuts: Behind the numbers

To better understand the risks facing Lockheed, you need to know that what Washington insiders describe as "automatic spending reductions" are neither automatic nor reductions. For one thing, they aren't scheduled to take effect until 2013. Congress and the President, which wrote them into law last summer as an incentive for the supercommittee to act, can undo them. That's what Lockheed, Panetta, and many leading Republicans would like to see happen. Senators John McCain of Arizona and Lindsey Graham of South Carolina said last week they will "pursue all options" to avoid deeper defense cuts, which "cannot be allowed to occur."

What's more, the $1 trillion represents the difference between the current and previous forecasts, and it includes $500 billion in savings already agreed to by the Pentagon. "That cut actually gives you 1.5% compounded growth over 10 years," explains Scott Thompson, U.S. aerospace leader at PwC. Lawrence Korb, a former assistant secretary of defense in the Reagan administration, agrees, saying, "There are no reductions. Defense would still grow, but not as fast."

The numbers can be spun in a variety of ways. Deloitte's Tom Captain argues that the past decade's growth in Pentagon spending came off a very low base. "As a percentage of GDP, [defense spending] is less than 4%, low by historical standards," Captain says. On the other hand, Pentagon spending has grown despite the mushrooming budget deficit and a sluggish U.S. economy. As a result, the U.S. now accounts for 42% of global military spending, but just 23% of global GDP.

As the budget battles unfold, Lockheed's priority will be to protect the F-35, a stealth fighter that can evade enemy missiles, but a juicy target for those who want to rein in Pentagon spending. Lockheed won the contract to develop and produce more than 2,800 of the jet fighters for the Air Force, Navy, and Marines back in 2001 at a cost then estimated at about $233 billion. European and Asian allies have agreed to order another 700 planes, in part to enable better coordination of joint operations. Each branch of the armed forces will get its own, customized versions of the jet; Marines, for instance, will fly a plane that can take off from a small ship or remote base and land vertically, like a helicopter. The F-35 program, it was hoped, would capture economies of scale because the fixed costs of designing, developing, and testing new aircraft would be spread across thousands of planes. What's more, all the aircraft would share a software platform and use common parts, keeping costs down.

lockheed_martin_productionIt hasn't worked out that way. The program's overall cost has soared by 64% to $382 billion, according to the Government Accountability Office, an arm of Congress. Meanwhile, the average cost per plane, including development, testing, and production, has nearly doubled, from $69 million to $133 million. "Affordability is no longer embraced as a core pillar," an internal Pentagon report said last year. Defense industry critics warned of problems with the F-35 from the very beginning; now even political moderates want the scope of the program to be curbed.

The politics of the F-35 are complicated. To build the fighter jets, Lockheed and its 1,300 domestic suppliers do business in 47 states; they account for 127,000 direct and indirect private-sector jobs, according to the company. Even members of Congress who preach fiscal restraint hate to eliminate jobs in their backyards. But when given a choice between eliminating a weapons program or reducing salaries, health care costs, or pension benefits for active-duty soldiers or veterans, most legislators will vote to cut procurement. And the problems with the F-35 have alienated some longtime friends of the military, like U.S. Sen. John McCain, Last summer McCain wrote on Twitter: "Congress notified that first F-35 jets have cost overruns of $771M. Outrageous!"

Stevens told Fortune that the cost and reliability problems with the F-35 are being resolved. "Nobody has undertaken a program of this scale, this magnitude, this sophistication before," Stevens says. "I have every confidence this airplane is going to work superbly well. Our reputations are on the line." He told analysts recently that Lockheed and the government are negotiating over who should bear the cost of changes to the aircraft, which is being manufactured even though thousands of hours of flight testing lie ahead.

Lockheed's critics say the billions of dollars being poured into programs like the F-35 are unrelated to any real military threat: If you add up the defense budgets of China, Russia, Iran, North Korea, and Cuba and then double that sum, the U.S. still spends more, they say. But Stevens sees danger everywhere. "Over the last 20 years or so," Stevens notes, "our armed forces have been worked hard, with major deployments in Panama, Iraq, Somalia, Haiti, the Balkans, Kosovo, Iraq again, Afghanistan, and a no-fly zone in Libya. Now is not the time to under-invest in our military or the capabilities they need to keep our nation free and strong." Other military experts agree that the U.S. needs to prepare for a period of "persistent conflicts." Give peace a chance? Not if Lockheed has its way.

Update: An earlier version of this story said the defense spending cuts could total $1 billion over ten years. They could total $1 trillion.

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