Case 20 Lockheed Martin Jim Kelly, Eric Ryza, Mark Herman, Norbert Forlemu, Swetha Manimuthu Texas A&M University Lockheed Martin takes flight in times of crisis.1 Vividfour / Shutterstock.com Introduction It's a plane. It's a helicopter. Actually, it's the Lockheed Martin F-35 Lightning II, the most capable - and expensive - aircraft ever produced. Like a jet that can also hover, Lockheed's versatility is its greatest strength in times of crisis. Along with the escalation of conflicts in the Middle East and increased support for defense spending, Lockheed Martin's stock rose dramatically from a price per share of $31 in January 2001 to over $120 in mid-2008.2 However, as of the end of 2011 and coinciding with the drawdown in Iraq and Afghanistan, Lockheed's stock dropped to $80.90. Nevertheless, Lockheed enjoyed an outstanding return on equity (ROE) of 112 percent in 2011. With four core business segments and a worldwide reputation for excellence, Lockheed appears well positioned to respond to changes in the market. However, fully 78 percent of Lockheed's total sales are from military arms3 and 82 percent of total sales originate from within the United States. Simply put, Lockheed's dependence on U.S. defense spending has the potential to threaten the firm's longevity. Lockheed Martin alone receives over 7 percent of total U.S. defense spending - that's one of every fourteen dollars paid by the Pentagon. Yet in times of economic crisis, this funding is threatened at all levels and has resulted in uneven cash flows and company-wide layoffs. Recently, Lockheed downsized its workforce from 146,000 to 123,000,4 reflecting the termination of key projects and a forecasted reduction in demand for both existing and new products. The early termination of the F-22 Raptor project in 2008 illustrates the potentially devastating effects of government budget constraints on the survivability of Lockheed. The F-35 Joint Strike Fighter currently in development has the potential to be the largest weapons project ever, with an estimated $1.51 trillion final tally.5 However, production delays and the current political climate threaten to affect the scope of the project dramatically - a project at the core of Lockheed Martin's fiscal security. Further, if Lockheed's fortunes improve in times of global unrest, reason suggests that the company suffers in times of peace and stability. Lockheed's challenge is delivering products with a 10- to 20-year development and production lead time that, ultimately, will be in uncertain demand (due to the impossible-to-predict state of flux in terms of world conflict) for customers with uncertain budgets. Lockheed's recent exploration into renewable energy and healthcare solutions adds an interesting dimension to its portfolio, as both are new business segments and outside the usual scope of its core competencies. Taking Flight Lockheed started when two brothers, Allan and Malcolm Loughead (pronounced \"lock-heed\"), handcrafted their first wooden planes in southern California in early 1913, mainly for hobbyists and as a military model. They were successful until the end of WWI left their business without a market and the company went bankrupt in 1921. Allan Loughead continued alone, collaborating with Fred Keeler to form the Lockheed Aircraft Company in 1926. Their first success was the Vega wooden monoplane, which made the first nonstop transcontinenal flight across the United States in 1928. This success inspired the Detroit Aircraft Corporation (DAC) to acquire the company in 1929. The new company thrived 259 260 through WWII and produced multiple aviation legends such as the P-38 Lightning Fighter, the U-2 spy plane, and the SR-71 Blackbird. Lockheed also produced the XP-80 Shooting Star, the first American jet fighter, in only eight months. In the 1960s, Lockheed attempted to enter the commercial jumbo jet market to compete with Boeing's then new 747 and the McDonnell-Douglas DC-10. As a late mover pitted against superior competition, Lockheed conceded defeat in 1972. On the brink of bankruptcy, Lockheed remained solvent through a $250 million loan guarantee from the U.S. government.6 To add insult to injury, Lockheed's image was marred in the 1970s by a major bribery scandal. This scandal led to tougher U.S. anti-bribery laws and a new process called Total Package Pricing that is designed to make bidding more transparent and explicit.7 Lockheed came out of the 1970s to prosper during the 1980s, winning new contracts for the F-117 stealth fighter and acquiring the division of General Dynamics responsible for producing the popular F-16. Merger of Equals The Martin Company was formed in 1917 by Glenn Martin who built his first airplane in 1909 and later merged with the Wright brothers. The company is notable for producing the first U.S.-constructed bomber, the B-29, as well as commercial and military flying boats.8 The company produced missiles, electronics, and nuclear systems in the 1950s, and, in 1961, it merged with American Marietta Company, a construction materials and chemical company. The newly named Martin Marietta Corporation sold most of its businesses after incurring excessive debts to defend a hostile takeover, but in 1992, managed to purchase GE's aerospace business. In March 1995, the company merged with Lockheed to form Lockheed Martin, the largest defense contractor in the world. This so-called \"merger of equals\" was hailed by investors and others as a \"rare instance of corporate synergy\"9 as the two companies were competitors, yet with minimal areas of overlap in specialties and capabilities. The newly formed Lockheed Martin continued its expansion in 1996 by acquiring the Loral Corporation and COMSAT Mobile Communications. Because of low profits, the company then divested ten of its noncore technology operations and acquired a 30 percent stake in Asia Cellular Satellite to build its non-defense business. Shortly thereafter in 2000, Lockheed Martin was awarded a $3.97 billion contract by the Pentagon to develop an anti-missile system as well as a contract to supply 24 C-130J transports.10 Part 4: Cases Lockheed Martin continued to expand by acquiring the government technology services business of Affiliated Computer Services in 2003, and Sippican, a naval electronics company, in 2004. In the same year, it won a seven-year contract to provide information technology services to the Social Security Administration. The company had another successful year in 2005 when it was selected alongside Augusta Westland to build a new fleet of 23 presidential Marine One helicopters. It also acquired STASYS Ltd., a U.K.-based network communications company, and Systex Group, a provider of IT and technical support services to the U.S. government in the same year. In 2006, it acquired several businesses including ISX Corporation, Pacific Architects and Engineers, and Savi Technology. The company's Space Systems division also won the coveted Orion manned lunar spaceship contract from the National Aeronautics and Space Administration (NASA) that year. In 2007, Lockheed Martin combined its Information Technology and Global Services division with its Integrated Systems and Solutions division. Recognizing its limitations, the company collaborated with rivals Northrop Grumman and Alliant Techsystems to develop multirole weapons for Lockheed's F-22 Raptor and F-35 Lightning II.11 Despite Lockheed's efforts to build the capabilities necessary to fulfill its contracts, the F-22 Raptor was cancelled in late 2008 by the Secretary of Defense, Robert Gates, due to budget constraints. The F-22 was originally developed to combat Cold War threats by providing complete air superiority. At a cost of $354 million per plane,12 however, this technology and capability was no longer justifiable. In addition, concerns about the acquisitions process as well as issues with program development and high costs led President Obama to cancel the VH-71 presidential helicopter contract in early 2009. To add to its woes, the future of the F-35 and Lockheed's relationships with eight partner countriesi remains in jeopardy due to increasing costs and delays. The Industry: Anything but Stable Lockheed Martin has four business segments that primarily cater to customers in the defense segment: Aeronautics, Space Systems, Electronic Systems, and Information Systems and Global Solutions.13 Britain, Australia, Italy, Turkey, Norway, Denmark, the Netherlands, and Canada. i 261 Case 20: Lockheed Martin Aeronautics The aircraft industry comprises about 80 percent of the aeronautics industry. The growth of the airplane industry began with the Wright brothers' successful demonstration of wing dynamics to the American and European governments. After the successful use of aircraft in WWI, the U.S. government began to focus on military aircraft. This transformation led to the emergence and success of many entrepreneurs in the race for military aircraft superiority, most notably Boeing, Douglas, Loughead, and Martin. The conclusion of WWI and subsequent cancellation of over 90 percent of the defense contracts eliminated most of the smaller entrepreneurial ventures in this industry, leaving only the major players that have since grown to be leaders largely through mergers and acquisitions. The aircraft industry consists of aircraft and aircraft parts for both military and civilian purposes, with aircraft sales accounting for 65 percent of the industry's revenues. Currently, Lockheed Martin is the industry leader for defense aircraft followed by Boeing and Northrop Grumman Corp. The commercial aircraft industry tends to follow economic recessions and booms. On the other hand, the military aircraft industry is driven by international policies and conflicts that drive fiscal policies and defense budgets. Accounting for 60 percent of revenue, government defense contracts strongly influence sales in the aeronautics industry. The emergence of this industry followed two historic incidents: the development of airborne missiles during WWII and the \"race to space\" of the U.S. and the U.S.S.R. After WWII, most aviationfocused companies began to develop missile technology. The growth of this industry closely follows occurrences of war and major political changes, such as the fall of the U.S.S.R. The aeronautics industry has three segments: ballistic missiles, cruise missiles, and space vehicles. Because of the complexities of hardware and software involved, this industry is highly collaborative with one contractor sub-contracting to others. Until the fall of the Iron Curtain, the market for missiles experienced strong growth. However, after the fall of the U.S.S.R, the demand for missiles dropped significantly as the expected need for both ballistic and aircraftfired missiles declined. A major impact in this industry was the Strategic Arms Reduction Treaty between the U.S. and U.S.S.R., signed in 1991. According to the treaty, member nations would discontinue building guided and ballistic missiles and would destroy 30 percent of their respective ballistic missile stockpiles. The treaty was valid for 15 years with clear enforcement periods for reducing various missiles. This treaty was re-signed in 2010 and further reduced the number of warheads and launchers in deployment by each country. The industry experienced a significant growth spurt when the contracts for missiles grew in 2004 in relation to the war in Afghanistan and Iraq, but this growth slowed in the second half of the decade. To ensure survival in the face of decreased business potential and in response to pressure to decrease costs, multiple mergers and acquisitions have occurred in the aeronautics industry. Additionally, multiple collaborative partnerships have been formed in this industry since the late 1990s as another path for industry participants to continue operating. The industry largely depends on the effect international tensions wield on defense spending, and to a smaller degree, economic conditions.14,15 Space Systems The space system industry has three segments: space capsules with rocket boosters, re-entry vehicles, and satellites. Before the Iron Curtain's fall, the United States and the U.S.S.R. were competing on several space missions - most notably, launching satellites and sending a person to the moon. This industry grew with government spending to launch both communications satellites and the International Space Station into orbit in the 1990s. Manned missions slowed after the Challenger and Discovery tragedies. The industry now focuses on launch vehicles that put satellites into orbit, although this also leveled off around 2003.16 Electronic Systems Perhaps surprisingly, the electronic systems segment of Lockheed Martin accounts for 31 percent of the company's total revenue, posting higher net sales, operating profits, inter-segment revenue, and international sales than the firm's other three divisions. Even so, Lockheed management felt that splitting the unit into two new divisions - Missiles and Fire Control (MFC) and Mission Systems and Training (MST) - would reduce costs and jump start revenue growth.17 At present, this division provides avionics, training systems, communications systems, engineering support, integration support, and other support systems for naval, missile, nuclear, and aircraft systems. Lockheed announced the split would become effective at the end of 2012. The electronic systems industry has a clear demarcation between government defense projects and commercial projects. The rules that govern the contracts of 262 these two sets of customers vary considerably. Federal contracts involve different processes, accounting procedures, and conformance to several government norms for the suppliers. Consequently, the cost of executing a defense contract is substantially higher than that of a similar commercial contract. Government contractors have numerous agencies to satisfy, all of whom monitor the pricing, quality, and performance of the products, in addition to adherence to the various standards regarding implementation. Contractors are subject to several audits and are required to disclose their financial information in view of the former requirements. Initially, the defense electronics industry negotiated electronics contracts separately from the larger, more comprehensive contracts. The average strike rate (how often a single contractor's bid is selected) for companies in this industry remains at 25 percent, a percentage the U.S. government has historically targeted. However, despite its efforts to reward contracts among the various contractors equally, some companies receive a larger share of the pie. These companies hold a stronghold in the defense market. As with the aeronautics industry, at one time there were many primary and secondary contractors in the electronics industry. However, with reductions to the defense budget since 1990, this has changed. Significant mergers among the larger companies put secondary contractors in a precarious situation. This merger activity, a preference for the larger companies, and government policies requiring a smaller and well-diversified contractor base, further reduced the number of the companies competing in this industry. Because of this reduction, the government now rewards contracts for whole systems instead of individual components and sub-systems using a competitive and transparent \"request for proposal\" bidding process. Although investment in property, plant, and equipment required for this industry is low, because of government policies several deterrents for start-ups remain. Chief among these deterrents are specialized human resources, continuous facility improvements and cost reductions, intense national and international competition, and ongoing technology obsolescence. Research and development (R&D) is integral to this industry, with funding for R&D coming explicitly from the contracts being awarded and government subsidies. This funding was implemented to ensure that a company could become the sole contractor for a proprietary technology and thereby capitalize on innovation. Despite the goal however, this funding began to decrease in the 1990s. Part 4: Cases The industry grew in the early 2000s with the U.S. military initiative to integrate and upgrade its systems into what it called the Future Combat System. Another significant contribution to the growth of the industry was the increase in demand for Global Positioning Systems (GPS) in both the defense and commercial segments, with navigation systems first being utilized in a defense capacity during the Gulf War conflict in 1991. The launch of the GPS-2RM satellite by Lockheed Martin in 2005 increased the power available for existing signals and added additional frequencies for military and civilian GPS use. The third factor contributing to the growth of the electronics industry is the U.S. Army's recent development of a protection system for Stryker units that scans for and intercepts anti-tank missiles and grenades. As with the aeronautics and space systems segments and despite its growth in the civilian market, this industry is affected significantly by reductions in defense budgets. Lockheed Martin is the industry leader for electronic systems. This is due to additional capabilities resulting from the merger of Lockheed and Martin and Martin's earlier acquisition of the GE Aerospace division. Raytheon is the second largest company in this industry, followed by AlliedSignal's recent acquisition - Honeywell. In addition, there are many other companies with well-diversified business portfolios operating in this industry.18 Information Solutions Systems and Global Information systems and global solutions is the fourth industry and segment of Lockheed Martin. This business segment provides management services, information systems, and technology expertise to a wide variety of customer segments including biometrics, energy, financial services, human capital management, healthcare, transportation, and homeland security. This is a very competitive industry with large and small cap companies. With only 2 percent of this division's revenue originating from commercial customers in the United States and 5 percent from international customers, it is obvious that the purchases by the U.S. government account for the majority of the segment's revenues.19 How Lockheed Martin Competes Lockheed Martin is committed to delivering superior shareholder returns while pursuing leading sustainability performance and good citizenship. - Bob Stevens, CEO20 263 Case 20: Lockheed Martin Lockheed Martin operates using four principles - Secure, Extend, Expand, and Enable. Secure our existing programs by performing with excellence. Additionally, we must continue to have candid dialogues with our customers and the highest degree of transparency on all our programs. Extend the value of our platforms by shaping followon business and tailoring our existing capabilities for new applications. We should also continue to seek and implement innovative business models. Expand our position within targeted segments with market-based strategies. This also means more pursuits internationally, and greater synergies between Lockheed Martin products. Enable meaningful growth through adjacent market opportunities. We want to focus on markets that will move the needle for us.21 Conditions in the external environment strongly influence the strategies Lockheed Martin uses in its Aeronautics, Space Systems, and Electronics Systems divisions. In this sense, these divisions have identified the technologies that will satisfy market demand and then use its resources, capabilities, and core competencies to satisfy those demands. In contrast, available resources and their relative uniqueness that are associated with the firm's Information Systems and Global Systems segment strongly influence how this particular segment competes. More specifically, Lockheed Martin identified the IT industry to be one in which the firm's capabilities and core competencies could be successfully applied in order to create value for customers. Accordingly, it now offers technology solutions to the energy, healthcare, and financial services sectors, among others, - which is a definitive move away from the U.S. defense budget (Exhibit 1). Lockheed Martin provides aircraft and advanced technology solutions to its customers, primarily the U.S. government. The firm emphasizes innovation, human capital, and ethical practices as the foundation for serving customers' needs. Over its life, Lockheed Martin has expanded its business operations and now operates well-diversified business segments. This diversification helps the firm weather economic downturns and defense-specific spending cuts. Diversification for Lockheed has primarily come through mergers and acquisitions, the most notable of which was the merger between Lockheed and Martin in 1995. Also of significant note was the acquisition of the advanced electronics company, Loral Corporation, in 1996.22 Lockheed Martin's business segments share Exhibit 1 Lockheed Martin Business Segment Basis Resource Basis I/O Basis Information Systems and Global Solutions Aeronautics Space Systems Electronics Systems Source: Lockheed Martin Corporation. Annual Report. Bethesda, MD: Lockheed Martin Corporation, 2011. Retrieved 07 Mar 2012. http://www.lockheedmartin. com/content/dam/lockheed/data/corporate/documents/2011-Annual-report.pdf capabilities and a culture defined by the executive leadership with a large amount of project-based cooperation between its aeronautics, space vehicle, and electronics business divisions. Lockheed Martin enjoys its position as a leader in the defense sector; however, U.S. government dependent businesses do not operate or compete in a risk-free environment. Successful performance in this sector involves, for example, keeping costs at an acceptable level while adhering to the many rules and regulations governing the firm's operations. Lockheed Martin focuses on continued operational efficiency and cost-controlling measures to remain attractive to its customers and shareholders alike. In view of this, it works closely with its suppliers, anticipating raw material prices and planning accordingly. It believes that solid execution is important and works to stay on schedule in development and production, although this has been a particular point of c ontention in the F-35 program. Innovation is the key to survival for any technology company and is an organizational activity to which Lockheed Martin devotes considerable resources. For example, anticipating the growth in demand for unmanned vehicles and global security services, Lockheed Martin is now investing heavily in the development of these types of systems and activities.23 It is attuned to the 264 Part 4: Cases behaviors of its customers and understands that managing costs is essential to its sustainability in a future with potential government budget cuts. In accordance with an interest to continue increasing its revenues and profitability as well, Lockheed Martin has focused on increasing international sales and expanding into adjacent markets. For example, the number of international customers for the F-35 aircraft has increased from eight to ten with the additions of Israel and Japan. Financial Data and Performance24,25,26,27,28,29,30,31,32 The 1995 combination of Lockheed and Martin resulted in a firm that was heavily dependent on the U.S. government for revenues. For example, Lockheed attributed 82, 84, and 85 percent of its 2009, 2010, and 2011 total revenues to products sold specifically to the U.S. government and its military allies (Exhibit 2). Relying on a single or a small number of customers for the majority of a firm's sales (as is the case for Lockheed) creates a dependence that is undesirable. The net profits of the company, totaling $2.66 billion in 2011, came from its four operating segments: Aerospace, Space Systems, Electronic Systems, and Information Systems and Global Solutions. Aerospace and Electronic Systems are the two dominant segments in the Lockheed portfolio, accounting for nearly 63 percent of the company's sales in 2011. Further, the Space Systems segment's only customers are NASA and the U.S. Department of Defense. Some Space System products are sold internationally, but the transfer is facilitated and regulated by the U.S. government. Given the aforementioned ties to the U.S. government's funding decisions relative to the firm's business segments, some might view Lockheed Martin as a risky investment. The long period of time that is commonly required for the firm's R&D investments to lead to revenue enhancements, coupled with the fact that the markets for its primary products are constrained by the political and legal external environment, could lead investors to believe there is relatively little room for growth in the company. According to Lockheed's financials, however, those investors would be wrong. Largely because of its ability to innovate and collaborate, Lockheed Martin has been at the forefront of many technologically significant aerospace breakthroughs. Its ROE for 2011 of 112.76 percent exceeds the performances of all of its main competitors, with the exception of Boeing, which posted a 127.94 percent ROE over the same period. In contrast, Northrop Grumman, which predominantly manufactures systems and platforms, such as the E-2 Hawkeye and the Global Hawk unmanned aerial vehicle used extensively in the war on terror, earned only a 17.73 percent ROE. Industry giant General Dynamics was only slightly better for 2011 with a ROE of 19.03 percent (Exhibit 3). While many investors would be very satisfied by a firm's ability to earn a 112.76 percent return on its equity, analyzing Lockheed's capital structure yields additional and important insight about the firm's overall financial performance. In this respect, Lockheed Martin earned only a 5.7 percent profit margin due in large part to its Exhibit 2 Percent of Revenue from U.S. Government Comparison 90% 80% 70% 60% 50% 2011 40% 2010 30% 2009 20% 10% 0% Lockheed Source: 2011 10-K filings of companies listed via www.sec.gov Boeing Northrop Grumman General Dynamics 265 Case 20: Lockheed Martin bidders are expected to adhere to the technical requirements specified. Cost is considered only after a bidder's satisfactory compliance to all technical specifications. Study of firms' financial situations suggests the possibility that there are no moderately financed companies in terms of capital structure within this industry, as both Lockheed Martin and Boeing are heavily leveraged, while General Dynamics and Northrop Grumman rely heavily on equity. The dichotomy between the two approaches is quite revealing. The two low-leverage companies, General Dynamics and Northrop Grumman, only have debt-to-asset ratios of 29.53 and 38.07 percent, respectively, which would be the reason for their \"less-thanspectacular\" return on equity. Leading its competitors in this segment, Lockheed Martin shows the most stable per share earnings over a five-year period ending in 2011, ranging from $7.02 to $7.81 (Exhibit 4). This may be one reason that institutions own 91 percent of the company's stock. By comparison, earnings per share for General Dynamics have ranged from $5.10 to $6.94 over this period, while the EPS for Northrop's stock has varied from $4.12 to $7.52. Perhaps surprisingly, Boeing's earnings-per-share have been the most volatile over this particular five-year period, ranging from a low of $1.87 diluted EPS in 2009 to a high of $5.33 in 2011. From an income statement perspective, the size and scope of Lockheed Martin can be quite difficult to comprehend fully. Lockheed Martin is a behemoth of an industry leader with annual revenues in excess of $40 billion for each of the last five years. The aerospace segment, only the second largest division in the company, had revenues in excess of $14 billion for 2011. Exhibit 3 2011 Return on Equity Comparison General Dynamics, 19. 03% Northrop Grumman, 17. 73% Lockheed, 112 .76% Boeing, 127.9 4% Source: 2011 10-K filings of companies listed via www.sec.gov significant debt. Its debt to assets ratio is 645 percent, giving pause to investors contemplating the possibility of purchasing stock in Lockheed Martin. Further, because the U.S. government is its predominant customer, all requests for proposals are put out to bid in a static fashion. The U.S. government has moved away from awarding contracts on a component and sub-system basis, now preferring to award entire systems to one contractor. Because cost is a major consideration, the government specifies the technical requirements but refrains from dictating production and development techniques. All Exhibit 4 Net Earnings per Share (Diluted) Comparison 9 8 7 6 5 4 3 2 1 0 2011 2010 2009 2008 Lockheed Boeing Northrop Grumman General Dynamics Source: 2011 10-K filings of companies listed via www.sec.gov 2007 266 Part 4: Cases For a company such as Lockheed Martin, the backlog of orders is an indicator of a firm's health that investors examine. Lockheed had a tremendous backlog of orders in excess of $30.5 billion for 2011, up $3 billion from the previous year. This backlog compared favorably with those of its competitors. Boeing had a reported backlog of $24.1 billion, down from $25.1 billion in 2010, and Northrop Grumman and General Dynamics' Combat Systems division had a $19.2 and $11.4 billion backlog by comparison. This bodes well for Lockheed, as the majority of its backlog cannot be attributed to any one system. The F-35 program accounts for a significant percentage of the firm's backlog, but the C-130, F-16, and C-5 all have plenty of demand in waiting for the next several years (Exhibit 5). With the high hopes of Lockheed for the program and the commitment from the U.S. government and some of its allies, the F-35 project is likely to be a long-lived program that sustains the company for decades to come. In fact, according to the Lockheed company analysis gathered from Business Source Complete, the program could generate revenues in excess of $1 trillion over the next several decades. Despite having been in production for several decades, several of the legacy programs including, for example, the F-16, still provide excellent returns for the firm. The C-130 program, along with all of the variant types manufactured, is seen on nearly every U.S. military installation and fulfills multiple roles for the different branches of the service. Additionally, the longerlived programs, again referring to the F-16, commonly experience customers in addition to the U.S. government deciding to buy the firm's products. For example, given its performance capabilities, governments representing Taiwan, India, and the United Arab Emirates have also purchased the F-16 over the last decade. Customers purchase products such as the F-16 primarily to upgrade the quality and capabilities of their fleets. As a final analysis, the compounded annual growth rate (CAGR) was calculated for Lockheed and its primary rivals. The industry did not fare well during the 2007 to 2011 period. The stock market's general decline in 2008 and 2009 accounts for some of these outcomes in terms of growth rates. On the other hand, final calculations place Lockheed's CAGR at 6.37 percent, besting the 7.14 percent of Northrop Grumman and the 7.12 percent of General Dynamics by 80 basis points or so, but falling behind Boeing's 4.30 percent CAGR for the same five year stretch (Exhibit 6). The interaction between the competitors in this industry is unique. Even with intense competition on certain fronts, many contract-based partnerships between companies exist. The F-22 is the product of one such partnership among Lockheed Martin, Pratt and Whitney, and Boeing. Boeing was responsible for the wings, aft fuselage, avionics integration, life support system, training system, fire protection system, and 70 percent of the mission software. Pratt and Whitney supplied the two engines, and Lockheed Martin was responsible for program management and the remainder of the aircraft's components. The F-22 was launched in 2007 in a ceremony hosted by all three companies.33 These partnerships have become common in the industry, particularly with companies pursuing similar projects and products. Typically, these partnerships exist so each firm can use its core competencies to Exhibit 5 Order Backlog Comparison (in millions) 35000 30000 25000 20000 2011 15000 2010 10000 2009 5000 0 Lockheed Aerospace Source: 2011 10-K filings of companies listed via www.sec.gov Boeing Military Aircraft Northrop Grumman Aerospace Systems General Dynamics Combat Systems 267 Case 20: Lockheed Martin contribute to the mission specified within each individual project. Ethics The very nature of being a defense contractor means that the market is very narrow and a competitor's gain is another firm's loss. There have been several very high profile examples of corporate espionage, scheming, and illegal activities such as bribes throughout the history of the industry as firms vie for competitive advantage. Lockheed itself was embroiled in scandal in the 1970s after paying several bribes to foreign officials and political organizations in exchange for receiving several aerospace contracts. This scandal tarnished the image of the company, which had been known at that time more for financial troubles than for innovation.34 Another instance involved an engineer from Boeing who Lockheed hired in 2005. The two firms were battling for a multibillion-dollar long-term contract to produce long-range missiles for the U.S. defense department. The engineer Lockheed hired brought with him over 25,000 pages of documents relating to the project in contention. Boeing initially brought the issue to light by saying there were only seven pages, but as the investigation into possible wrongdoing expanded, complete records in excess of 25,000 pages referring to the Lockheed bid, all of which were confidential, proprietary information, were found.35 Over the last few decades however, Lockheed has re-engineered itself into a competitive juggernaut of defense and has developed a reputation for ethical and transparent dealings. Lockheed's strategic leaders are Exhibit 6 Compounded Annual Growth Rate Comparison, 2007 - 2011 Northrop Grumman, -7.14% General Dynamics, -7.12% Lockheed, -6.37% Boeing, -4.30% Source: 2011 10-K filings of companies listed via www.sec.gov working diligently to create a culture of accountability, ethical standards, and transparency. This direction has permeated the organization, and the company seems to be a beacon for the industry. As an example of the honesty and accountability of the firm, former CEO Robert Stevens took full responsibility for the cost overruns and production and development issues of the famed F-35 joint strike fighter program.36 The program director, Dan Crowley, had come under scrutiny for the issues with the program, but Stevens stepped up and took full accountability, giving Crowley a vote of confidence rather than using him as a scapegoat. The Pilots Our business is built on integrity, and we will not risk compromising it. - Bob Stevens, CEO37 Lockheed Martin is a large corporation by any reasonable measure. Of course, talented and effective strategic leaders are foundational to efforts for this firm to achieve strategic competitiveness and earn above-average returns. Overall, Lockheed Martin appears to have a top management team in place with the potential to help the firm successfully deal with the industry's challenges as well as the firm's challenges. Nonetheless, recent leadership-related upheavals have occurred within the firm. Following the traditional patterns of large cap, multinational corporations, Lockheed coupled the role of Chairman of the Board and CEO and, from 2004 until his retirement as CEO in early 2013, had entrusted the firm's direction and welfare to Robert J. Stevens.38 Stevens' Lockheed career started in 1993 and, based on Stevens' career trajectory at the nation's largest defense contractor and the firm's performance, it seems appropriate to give Stevens some credit for Lockheed's success. During his tenure at the helm, the corporation was awarded several billion-dollar government contracts, including the F-22 Raptor and the F-35 Lightning Stealth fighter programs and, along with the entire management team, he maintained Lockheed's position as a top defense contractor. Simultaneous to Stevens' retirement announcement in April 2012 was the announcement of his successor - the then current Vice Chairman, President, and COO, Chris Kubasik. However, with less than 60 days before taking the post, Kubasik was forced to resign \"after an internal ethics (investigation) found that he had a personal relationship with a subordinate that violated the company's code of ethics.\"39 The board immediately promoted Marillyn A. Hewson, Executive VP of the 268 Part 4: Cases Electronics Systems division, to assume Kubasik's positions (in addition to her own) - including the early 2013 promotion to CEO. At the same time, Lockheed announced that Stevens would assume the position of Board Executive Chairman until the end of 2013 \"to facilitate a smooth CEO transition.\"40 The Lockheed Martin Board of Directors includes some individuals who are well known and experienced. For example, three board members - Admiral (ret.) James Ellis, General (ret.) Joseph Ralston, and Admiral (ret.) James Loy - all served in distinguished positions in the Navy, Army, and Coast Guard, respectively. Additionally, all three had impressive and successful careers with organizations such as the Cohen Group and the Institute of Nuclear Power Operations. These individuals are key members of the board, largely because of their insights about the defense community and their contacts within that community (see Exhibit 7). Chain of Command Developing a strong managerial succession plan with respect to the firm's top management team is an important activity within Lockheed Martin. Lockheed's plan likely made it possible and even desirable for the firm to announce simultaneously Stevens' retirement and Kubasik's selection as his replacement. Subsequently, given the reported improper relationship with which Kubasik was involved, Lockheed relied on its succession plan to select Marillyn Hewson as the firm's new CEO. STRATEGIC CHALLENGES Declining Federal Defense Budget The U.S. military spending as a percentage of GDP is expected to decline to an average of 4.0 percent over the Exhibit 7 Lockheed Martin Board Members Adm. James Ellis Gen. J Joseph h Ralston R n Adm. James Loy Thomas Falk Nolan Archibald Robert Stevens C an nd Chairman and CEO Douglas McCorkindale Anne Stevens Gw wendolyn Gwendolyn King David Burrittt R d Rosalind B r Brewer Source: Lockheed Martin: Who We Are. http://www.lockheedmartin.com/us/who-we-are/corporate-governance/board.html 269 Case 20: Lockheed Martin next five years (2012-2016), down from 4.6 percent during the past five years (2007-2011).41 As a leader in the military aircraft segment, Lockheed's largest customer is the U.S. government, comprising 82 percent of 2011 sales.42 Therefore, an uncertain future for the U.S. government's defense budget poses a unique challenge with regard to investing in and growing the business. This is especially challenging given longterm projects such as the F-35, a product that has been in development since 1994. This project alone has required over a decade of development and it will be several more years before customers receive their first orders.43 Despite a temporary respite from worry when, in December 2011, Congress agreed to finance all U.S. government activities through September 30, 2012,44 Lockheed's management team receives little relief from having to attempt to predict the future to make decisions about the firm's strategies as well as their implementation. At the top of Lockheed's financial worries list is the Budget Control Act of 2011. This act can trigger automatic reductions in defense spending in January 2013 if Congress and the administration fail to reach a budget agreement.45 As stated in Lockheed's 2011 annual report, \"the resulting automatic across-the-board budget cuts in sequestration would have significant consequences to our business and industry.\"46 While Lockheed is diversified to some degree, this diversification cannot fully mitigate the impact of budget reductions resulting from sequestration. The termination of large U.S. defense contracts would adversely affect its business and future financial performance.47 Also on Lockheed's list of concerns are the steps being taken by the U.S. government to reduce its global commitments - as exemplified by its withdrawal from Iraq - this may further reduce the need for defense spending. International Market Risks Lockheed's international customers comprised 17 percent of 2011 net sales, and the firm plans to grow its international sales over the next several years48 despite the fact that the unpredictable nature of the international market segment poses even more challenges than Lockheed's domestic market \"due to the potential for greater volatility in foreign economic and political environments.\"49 Because of the ongoing global economic recession, foreign governments, especially those in European countries, have proposed a variety of budget cuts and austerity measures that may result in defense budget reductions. Dealing in foreign markets also exposes the firm to currency exchange risks since a weakening foreign currency can adversely impact profits when converted into U.S. dollars. Exporting to foreign countries, especially in the defense market, requires adherence to stringent export control policies. If a violation were to occur, the responsible business unit - or potentially Lockheed Martin as a whole - may be restricted from exporting products for a period of time. Other penalties could occur from not complying with industrial cooperation regulations as part of international business contracts. These offset contract agreements could potentially include meeting in-country purchase and manufacturing levels, sometimes for several years.50 Some opponents of this system argue that contract offsets are borderline bribes that promote corruption in foreign countries due to the lack of transparency, especially in the defense market where secrecy is mandated for national security reasons. \"The U.S. Department of Commerce Trade Promotion Coordinating Committee Report of March 2000 claimed that the defense sector accounted for 50 percent of all bribery allegations over 1994-1999.\"51 Nearly 130 different countries are estimated to use offset agreements, and the value of offsets has been increasing as a percentage of the main contract value.52 Regulation of the Defense Market The defense market customer base is severely limited due to constraints imposed by the U.S. government. All U.S. firms selling products internationally deal with trade embargos and restrictions with certain countries; however, additional scrutiny applies to the defense market because of concerns over national security as dictated by the International Traffic in Arms Regulations (ITAR). \"ITAR relates to Section 38 of the U.S.A.'s Arms Export Control Act (22 U.S.C. 2778), which authorizes the President to control the export and import of defense articles and defense services.\"53 In addition to the cost of the lengthy contract approval process because of ITAR, these regulations may deter foreign countries from accepting bids from U.S. companies such as Lockheed. In April 2011, India excluded Boeing and Lockheed from bidding on its $11B defense project for a new fighter jet. Many speculated this was due to growing restrictions on U.S. export policies related to ITAR.54 Even close U.S. allies such as the United Kingdom are becoming frustrated with the lengthy process ITAR imposes. However, conditions are improving with regard to a more efficient approval process for the United States' closest allies. \"In 2004 the processing time for all U.K.-related ITAR licenses was 22 days, compared to 42 days a few years ago.\"55 270 Part 4: Cases Although Lockheed Martin is highly experienced in the defense industry, it has violated ITAR policies in the past: In 2008, the Department of State charged Lockheed Martin with violations of the Arms Export Control Act and the ITAR for providing classified and unclassified technical data related to the sales of Hellfire missiles to the United Arab Emirates in 2003 through 2004.56 The outcome of these allegations resulted in Lockheed paying a $4 million civil fine. Despite this past violation, Lockheed's code of ethics clearly states its intentions to comply with the laws and regulations that govern its businesses.57 Controlling Costs Perhaps the most pressing challenge facing Lockheed Martin is its failure to control costs, specifically within the F-35 program. Lockheed has succeeded in producing a unique product for a discerning set of customers; however, it has failed to maintain an acceptable cost for the F-35, as evidenced by continually rising program costs estimated at 1.51 trillion.58 As a multi-role fighter with three distinct variants, the F-35 is slated to replace legacy fighters such as the F-16, F-18, A-10, and now fill the role of the forlorn F-22. Thus, the versatility demanded of the F-35 has carried significant costs. Lockheed Martin obviously underestimated the cost to develop such an aircraft and is struggling to provide the features required at an acceptable cost. As a result, a number of partner countries have expressed concern over the per-unit cost of the F-35 and have threatened to cancel or reduce their contracts unless Lockheed meets certain milestones. Italy has already reduced its orders for the F-35 from an initial 131 to 90, largely due to austerity measures in the country, but also due to concerns about increasing costs.59 With every cost revision of the F-35, Lockheed Martin must justify an increase in contract value to its customers.60 Lockheed's inability to control costs with the F-35 program may hinder its ability to earn customers' trust with respect to price and time estimates for its other products. The delays and cost overruns have plagued the aircraft industry as a whole, and this is especially true with tactical aircraft. Since the first plane produced by the Wright brothers, the costs to produce increasingly complex airplanes has increased exponentially. \"By 2054, if that rate continues, the cost of a single combat airplane will equal the entire projected defense budget.\"61 In fact, former Lockheed CEO Norman Augustine joked that the Navy and Air Force would have to share the jet for three and one-half days each per week62 and provided a chart to show the exponential increase in costs over time. Many countries have considered prolonging or increasing the use of the F-16 as a low-cost, combat-proven alternative if the F-35 delays and increasing costs continue. Thus, as Lockheed Martin looks to the future, it faces challenges with respect to its current operations as well as a host of challenging decisions about how to best position the firm to succeed in the years to come. Notes 1. 2. 3. 4. 5. Hoover's Online. Lockheed Martin Corporation Profile. Retrieved 28 Feb 2012 from Hoover's Online. \"This Defense Company Has 24% Upside - Even with the Pentagon's Spending Cuts.\" Money Morning. Retrieved 08 Feb 2012. http://moneymorning.com/2012/02/08/ this-defense-company-has-24-upside-evenwith-the-pentagons-spending-cuts/ \"The SIPRI Top 100 Arms-producing and Military Services Companies, 2010.\" www.sipri. org. Retrieved 03 Mar 2012. http://www.sipri. org/research/armaments/production/Top100 \"Absolute Freedom.\" Lockheed Martin. Supporting the Warfighter. 22 Feb 2012. Retrieved 24 Mar 2012. http:// www.lockheedmartin.com/us/news/ speeches/022212-hewson.html \"Lockheed F-35 Cost Estimate by U.S. Increases 9% in Year.\" Bloomberg. 30 Mar 2012. Retrieved 03 Apr 2012. 6. 7. 8. 9. 10. 11. 12. http://www.bloomberg.com/news/201203-30/lockheed-f-35-fighter-estimateincreased-9-in-a-year-u-s-says.html Terris, Daniel. Ethics at Work: Creating Virtue in an American Corporation. Waltham, MA: Brandeis UP, 2005. Ibid. Hoover's Online. Lockheed Martin Corporation Profile. op cit. Terris, Daniel. Ethics at Work: Creating Virtue in an American Corporation. Waltham, MA: Brandeis UP, 2005. p. 69. Hoover's Online. Lockheed Martin Corporation Profile. op cit. Ibid. \"Catch F-22 for Obama.\" The Christian Science Monitor. The Christian Science Monitor, 04 Mar 2009. Retrieved 08 Mar 2012. http://www.csmonitor. com/Commentary/the-monitorsview/2009/0304/p08s01-comv.html 13. 14. 15. 16. 17. Lockheed Martin Corporation. Annual Report. Bethesda, MD: Lockheed Martin Corporation, 2011. Retrieved 07 Mar 2012. http://www.lockheedmartin.com/ content/dam/lockheed/data/corporate/ documents/2011-Annual-report.pdf \"Aircraft.\" Encyclopedia of American Industries, Online Edition. Gale, 2011. (SICs: 3721) \"Manufacturers of Guided Missiles and Space Vehicles.\" Encyclopedia of American Industries, Online Edition. Gale, 2012. (SICs: 3761) Ibid. Fryer-Biggs, Zachary. \"Lockheed Martin Announces Split of Electronic Systems Division.\" DefenseNews. 8 Oct 2012. Retrieved 19 Mar 2013. http://www. defensenews.com/article/20121008/ DEFREG02/310080003/Lockheed-MartinAnnounces-Split-Electronic-SystemsDivision 271 Case 20: Lockheed Martin 18. 19. 20. 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. 31. \"Search, Detection, Navigation, Guidance, Aeronautical, and Nautical Systems and Instruments.\" Encyclopedia of American Industries, Online Edition. Gale, 2011. (SICs: 3812) Lockheed Martin Corporation. Annual Report. op cit. \"Absolute Freedom.\" Lockheed Martin Our Leadership Commits. Retrieved 24 Feb 2012. http://www.lockheedmartin.com/ us/who-we-are/sustainability/leadershipcommitment.html Lockheed Martin Corporation. Annual Report. op cit. Hoover's Online. Lockheed Martin Corporation Profile. op cit. \"Lockheed Martin Corporation, Company Profile.\" op cit. \"Lockheed Martin Corporation 2009 Form 10-K.\" U.S. Securities and Exchange Commission (Home Page). 25 Feb. 2010. Retrieved 8 Apr 2012. http://www.sec.gov/Archives/edgar/ data/936468/000119312510040520/d10k.htm Lockheed Martin Corporation. Annual Report. op cit. \"Lockheed Martin Corporation, Company Profile.\" op cit. \"Northrop Grumman Corporation 2009 Form 10-K.\" U.S. Securities and Exchange Commission (Home Page). 09 Feb 2010. Retrieved 08 Apr 2012. http://www.sec.gov/Archives/edgar/ data/1133421/000095012310010126/ v54508e10vk.htm \"Northrop Grumman Corporation 2011 Form 10-K.\" U.S. Securities and Exchange Commission (Home Page). 08 Feb 2012. Retrieved 08 Mar 2012. http://www.sec.gov/Archives/edgar/ data/1133421/000119312512045323/ d250683d10k.htm \"The Boeing Company 2009 Form 10-K.\" U.S. Securities and Exchange Commission (Home Page). 08 Feb 2010. Retrieved 08 Apr 2012. http://www.sec.gov/Archives/edgar/ data/12927/000119312510024406/d10k.htm \"The Boeing Company 2011 Form 10-K.\" U.S. Securities and Exchange Commission (Home Page). 09 Feb 2012. Retrieved 08 Mar 2012. http://www.sec.gov/Archives/ edgar/data/12927/000119312512048565/ d255574d10k.htm \"General Dynamics 2009 Form 10-K.\" U.S. Securities and Exchange Commission (Home Page). 19 Feb 2010. Retrieved 08 Apr 2012. http://www.sec.gov/Archives/edgar/ data/40533/000119312510034883/000119312510-034883-index.htm 32. 33. 34. 35. 36. 37. 38. 39. 40. 41. 42. 43. \"General Dynamics 2011 Form 10-K.\" U.S. Securities and Exchange Commission (Home Page). 17 Feb 2012. Retrieved 8 Apr 2012. http://www.sec.gov/Archives/ edgar/data/40533/000119312512066385/ d271667d10k.htm \"History - F22 Raptor.\" Boeing. Retrieved 10 Mar 2012. http://www.boeing.com/history/ boeing/f22.html \"SCANDALS: Lockheed's Defiance: A Right to Bribe?\" Time Magazine U.S. 18 Aug 1975. Retrieved 24 Mar 2012. http://www.time. com/time/magazine/article/0,9171,917751,00. html Bowermaster, David. \"Boeing Probe Intensifies over Secret Lockheed Papers.\" The Seattle Times. 09 Jan 2005. Retrieved 1 Apr 2012. http://seattletimes.nwsource.com/ html/businesstechnology/2002146025_ boeinglockheed09.html Butler, Amy. \"Lockheed CEO Stands By Company Leadership\" Aviation Week. 04 Mar 2010. Retrieved 15 Mar 2012. http:// www.aviationweek.com/aw/generic/story_ generic.jsp?channel=aerospacedaily&id= news/asd/2010/03/05/04.xml&headline= Lockheed%20CEO%20Stands%20By%20 Company%20JSF%20Leadership \"Absolute Freedom.\" op cit. \"CEO Profile of Robert Stevens.\" Forbes. Retrieved 12 Apr 2012. http:// people.forbes. com/profile/robert-j-stevens/49897 \"Christopher Kubasik, Lockheed Exec Ousted Over Inappropriate Relationship, To Receive $3.5 Million.\" Huff Post Business. 12 Nov 2012. Retrieved 16 Mar 2013. http:// www.huffingtonpost.com/2012/11/12/ christopher-kubasik-separationpackage_n_2117840.html \"Lockheed Martin Board Elects Marillyn Hewson CEO & President and Member of the Board.\" Lockheed Martin, Press Releases, 2012, November. 9 Nov 2012. Retrieved 16 Mar 2013. http://www.lockheedmartin. com/us/news/press-releases/2012/ november/110912-corp-leadership.html \"The U.S. Defense Market 2012-2016: Market Opportunities & Challenges.\" ICD Research. 29 Feb 2012. Retrieved 7 Mar 2012. http:// defense-update.com/20120229_the-us-defense-market-2012-2016-marketopportunities-challenges.html Lockheed Martin Corporation. Annual Report. op cit. \"Lockheed F-35 Cost Estimate by U.S. Increases 9% in Year.\" Bloomberg. 30 Mar 2012. Retrieved 3 Apr 2012. http:// www.bloomberg.com/news/2012-03-30/ 44. 45. 46. 47. 48. 49. 50. 51. 52. 53. 54. 55. 56. 57. 58. 59. 60. 61. 62. lockheed-f-35-fighter-estimate-increased-9in-a-year-u-s-says.html Lockheed Martin Corporation. Annual Report. op cit. Ibid, p.9. Ibid, p.9. Ibid, p.9. Ibid, p.11. Ibid, p.11 Ibid, p.11. \"Defense Offsets, Addressing the Risk of Corruption & Raising Transparency.\" Transparency International. Apr 2010. p. 14. Retrieved 11 Mar 2012. http:// www.acrc.org.ua/assets/files/zvity_ ta_doslidzhennya/TI_Defence_Offset_ Report_20101.pdf Ibid. \"UK Warns U.S.A. Over ITAR Arms Restrictions.\" Defense Industry Daily. 1 Dec 2005. Retrieved 17 Apr 2012. http:// www.defenseindustrydaily.com/uk-warnsusa-over-itar-arms-restrictions-01549/ \"U.S. Industry Loses Big in India: Is ITAR to Blame?\" National Defense Industry Association blog. 28 Apr 2011. Retrieved 1 Apr 2012. http://www.freerepublic.com/ focus/f-news/2712314/posts \"UK Warns U.S.A. Over ITAR Arms Restrictions.\" op cit. \"Navigating ITAR Compliance.\" Melbourne Legal Team. Retrieved 13 Apr 2012. http:// www.melbournelegalteam.com/itarcompliance.html \"Setting the Standard, Code of Ethics and Business Conduct.\" Lockheed Martin. September 2011. Retrieved 12 Apr 2012. http://www.lockheedmartin.com/content/ dam/lockheed/data/corporate/documents/ setting-the-standard.pdf \"Lockheed F-35 Cost Estimate by U.S. Increases 9% in Year.\" op cit. \"Italy to Cut F-35 Fighter Jet Orders as Part of Defense Revamp.\" Bloomberg BusinessWeek. 16 Feb 2012. Retrieved 16 Apr 2012. http://www.businessweek.com/ news/2012-02-16/italy-to-cut-f-35-fighter-jetorders-as-part-of-defense-revamp.html Lockheed Martin Corporation. Annual Report. op cit. Kotter, J. \"Leading change: Why transformation efforts fail.\" Harvard Business Review (Vol. 73, p. 175). 1995, Boston, MA: Harvard Business School Publication Corp. \"The cost of weapons: Defence spending in a time of austerity.\" The Economist. 26 Aug 2010. Retrieved 17 Mar 2013. http:// www.economist.com/node/16886851