Finance on the Front Line

Defense contractors are benefiting from new controls their CFOs have installed.

In one case, building the $815 million LPD-17 amphibious transport ship for the Navy at the former Litton Avondale operations in New Orleans, Northrop estimates that a series of efficiencies will allow it to cut $100 million annually from the overall program, beginning in 2004. The benefit to Northrop from passing on the margin increases to the government? A congressional committee had put the LPD-17 on a list of programs being investigated for elimination because of their poor cost performance. And the ship is now off the list.

“There’s an example where by turning that program around, it saved the business base, and it will allow us to make money on the program in the future,” says Waugh.

The acquisitive Northrop, which recently agreed to buy space-systems company TRW Inc. for $7.8 billion in stock, has also attracted attention for its ability to integrate its targets quickly and efficiently. It has redesigned its business around ships, space systems, electronics, and unmanned surveillance aircraft like the Global Hawk, a star in the Afghan conflict; Northrop considers this approach a “battlefield management” strategy.

“Simulating” Efficiencies at L-3

Waugh says the greatest achievement of the Northrop finance department, though, may be its restructuring of management compensation, using a “warranted equity value” system. The system, started in 1994, now makes up 60 percent of the company’s cash bonuses, available to 7,000 of its 100,000 employees.

In the early 1990s, Waugh was looking for a metric that correlated better with stock-price movement. Northrop’s earlier programs, like those used by most defense contractors, set goals based on sales, margin, and cash. That wasn’t bad, says Waugh, “but you could drive cash and sacrifice margin, for example,” to the detriment of the overall company.

The new compensation approach, based on a cash-flow-return-on-investment model used by portfolio managers, assigns each individual operation at Northrop an imputed stock value reflecting debt and cash flow. That value must grow during the year for any bonus to be paid, and there are no exceptions — not even for CEO Kent Kresa or CFO Waugh. Since the Pentagon offers payments for such things as achieving program milestones, there are individual incentives for doing things that benefit program results — something that did not exist under the old incentive systems.

Among the “mezzanine” defense contractors, L-3 Communications has sought to grow with small to midsize defense acquisitions. And what makes the acquisitions good deals, says CFO LaPenta, is that these targets often have been far slower than the big contractors to learn about the benefits of tight financial controls.

“Eight times out of 10 we replace the vice president of finance,” he says. Like General Electric, New York­based L-3 Communications targets only those companies that are either number one or number two in their markets. Among the organizational changes L-3 installs: corporate must review new program bids, and all hires of more than $125,000 a year must go to CEO Frank Lanza and LaPenta for approval first.

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