Pentagon says cost cuts not aimed at profits

NEW YORK (Reuters) - The Pentagon’s chief arms buyer underscored on Wednesday the Defense Department’s determination to cut costs, but sought to reassure investors the initiative was not aimed at cutting industry profits.

“A profitable defense industry is in the national interest and we recognize that,” Ashton Carter, defense undersecretary for acquisition, technology and logistics, told an investment conference hosted by Credit Suisse and Aviation Week.

“The idea that you save money by cutting profit is not only illogical, it’s backwards,” he said, noting that defense acquisition officials were looking for ways to give defense companies incentives to improve productivity and cut costs.

The Pentagon is setting up a “superior supplier” program to reward companies with good performance on weapons programs and also wants to do more to support independent research efforts funding by companies themselves, he said.

“Profit is the way to incentivize productivity. That’s the way we’re thinking about it,” he said.

Recent analyst reports have portrayed defense stocks as less promising investments given tightening margins.

Michael Strianese, chief executive of L-3 Communications Holdings Inc, said the defense industry welcomed and supported the Pentagon’s increased focus on productivity and appreciated the department’s collaborative approach.

He told the conference the current defense budget environment was challenging, but “not going off a cliff.”

At the same time, he expressed concern that the efficiency drive was putting pressure on industry profit margins, and said his company would skip bidding for some contracts -- including a big linguist services contract -- if margins got too low.

“There are areas where the margins have contracted to the point where we are reacting to it with no bids,” he said. “If we don’t think the margins aren’t worth it, we won’t do it.”

He said the result would be that some contracts would shift to smaller firms that might not be able to handle the work.

Dennis Muilenburg, chief executive of Boeing Co’s defense business, said his company supported the Pentagon’s efficiency drive, but reforms were being implemented unevenly. For instance, extended government audits sometimes delayed the Pentagon’s ability to finalize contracts with companies, which dragged profit margins lower.

“We’re aligned on intent. We need to drive that into the contractual details,” he said.

Tom Captain, an analyst with Deloitte LLP, said the defense and aerospace sector’s profit margins had been between 9 percent to 12 percent in recent years, lower than other industrial companies. As a whole, the sector had already improved productivity by over 100 percent.

“The Defense Department could take a lesson from the private sector,” he added.

David Van Buren, assistant Air Force secretary for acquisition, told participants he was eager to hear from the industry about ways to cut costs and help make profits more robust.

“There is a way forward with industry,” he said.

Carter singled out the Pentagon’s biggest weapons program, Lockheed Martin Corp’s F-35 fighter program, saying more work was needed to get that program’s costs under control and ensure its total cost never reaches the $382 billion projected by Pentagon cost estimators.

“There isn’t going to be ever more money,” Carter said.

Van Buren told the conference the Pentagon’s recent low-rate production contract for a fourth batch of F-35 fighter planes was written to jibe with Carter’s 23 specific cost-cutting measures, including a move to fix price incentive contract terms sooner than initially expected.

He praised efforts by Boeing to cut overhead costs in its space division and said the Air Force was also working closely with Northrop Grumman Corp to reduce costs on the high-altitude unmanned Global Hawk aircraft.

Carter said the Defense Department had scrapped most weapons programs that were not performing well or were no longer needed, although a few terminations could still be announced. He gave no details on which programs could be cut.

The Pentagon was working hard to ensure that new weapons programs would be more cost-efficient than in the past. He noted the replacement for the Ohio class submarines that carry nuclear missiles, a new presidential helicopter, long-range strike for the Air Force and the Army’s new ground combat vehicle would all be structured to avoid the rampant cost growth of earlier weapons programs.

Carter hoped Congress would approve a plan by the Navy to buy new coastal warships from both Lockheed Martin and the U.S. unit of Australia’s Austal Ltd after both teams proposed lower than expected prices. The Pentagon rejected the initial pricing, deciding to buy just one ship, but changed its mind after the most recent bids were submitted.

Reporting by Andrea Shalal-Esa; editing by Andre Grenon