Business Environment and Trends
IDS is comprised of four reportable segments, which include A&WS, Network Systems, Support Systems and L&OS. IDS results reflect the new segment reporting structure effective January 1, 2003. Prior period results have been revised to reflect IDS's new segment reporting format.
The IDS business environment extends over multiple markets, including defense (A&WS, Network Systems and Support Systems segments), homeland security (Network Systems), space exploration (L&OS), and launch and satellites (L&OS). IDS derives over 85% of its revenue from sales to the U.S. Government and we are forecasting this business mix will remain at this level into the foreseeable future. Specifically, the primary customers of IDS are the U.S. Department of Defense (DoD) for our products in the defense market, the U.S. Department of Homeland Security for the homeland security market, NASA for the space exploration market, and the U.S. Government for the launch and satellites market. Since the trends associated with these markets impact IDS opportunities and risks in unique ways, the various environmental factors for each are discussed individually below.
Defense environment overview The DoD represents nearly 50% of the world's defense budget. The current defense environment is characterized by transformation and change in the face of shrinking force structure, aging platforms, and a level of operations and engagements worldwide that we expect will remain high for the foreseeable future. The United States' leadership in the global war on terrorism demonstrates the value of networked intelligence, surveillance and communications, interoperability across platforms, services and forces, and the leveraging effects of precise, persistent, and selective engagement. The significance and advantage of unmanned systems to perform many of these tasks is growing. These experiences are driving the DoD, along with militaries worldwide to transform their forces and the way they operate. Network-centric warfare is at the heart of this force transformation.
We continue to see near-term growth in the DoD budget and a focus on transformation that will provide opportunities for IDS products in the future. However, with a softening global economy and anticipated federal budget deficits, allocations to DoD procurement are unlikely to increase significantly. This suggests that the DoD will continue to focus on affordability strategies emphasizing network-centric operations, joint interoperability, long range strike, unmanned air combat and reconnaissance vehicles, precision guided weapons and continued privatization of logistics and support activities as a means to improve overall effectiveness while maintaining control over costs.
Military transformation The defense transformation is evidenced by a trend toward smaller more capable, interoperable, and technologically advanced forces. To achieve these capabilities, a transformation in acquisition is underway that advances an increasing trend toward early deployment of initial program capabilities followed by subsequent incremental improvements, cooperative international development programs and a demonstrated willingness to explore new forms of development, acquisition and support. Along with these trends, new system procurements are being evaluated for the degree to which they support the concept of jointness and interoperability among the services.
Institutions and events continue to shape the defense environment. The DoD's implementation of a new Joint Capabilities Integration and Development Systems organization and process, along with revisions to the Defense Acquisition System, Program Planning Budgeting and Execution processes and the establishment of the Office of Force Transformation, has created a durable institutional foundation for continued transformation. Operations in the continuing global war on terrorism reaffirms the need for the rapid projection of decisive combat power around the world and emphasize the need for new capabilities and solutions for the warfighter. They also highlight the need for improved logistics and stability operation capabilities at completion of hostilities. Toward that end, the DoD is fully committed to a transformation that will achieve and maintain advantages through changes in operational concepts, organizational structure and technologies that significantly improve warfighting capabilities.
Missile defense Another significant area of growth and transformation relates to efforts being made in missile defense. Funding for the missile defense market is primarily driven by the U.S. Government Missile Defense Agency (MDA) budget. The primary thrusts in this market are the continued development and deployment of theater missile defense systems and the Ground-Based Missile Defense (GMD) program. The overall MDA missile defense budget for 2004 is approximately $9 billion.
Over the past year, emphasis has been placed on meeting President Bush's call to deploy a national missile defense capability by late 2004. Congress demonstrated support for this effort, as the funding for deployment has remained a top MDA budget priority. Through IDS's leadership position on the Missile Defense National Team and its prime contractor role on the GMD segment program and on the Airborne Laser program, IDS is positioned to maintain its role as MDA's number one contractor.
Defense competitive environment The global competitive environment continues to intensify, with increased focus on the U.S. defense market, the world's largest and most attractive. IDS faces strong competition in all market segments, primarily from Lockheed Martin, Raytheon and Northrop Grumman. BAE Systems and EADS continue to build a strategic presence in the U.S. market strengthening their North American operations and partnering with U.S. defense companies.
We expect industry consolidation, partnering, and market concentration to continue. Prime contractors will continue to partner or serve as major suppliers to each other on various programs and will perform targeted acquisitions to fill technology or customer gaps. At the lower tiers, consolidation persists and select companies have been positioning for larger roles, especially in the Aerospace Support market.
Homeland security environment The terrorist attacks on our nation on September 11, 2001 left a permanent impact on our government and the people and industries supporting it. President Bush issued an executive order establishing an Office of Homeland Security, and Governor Tom Ridge became the first Secretary of the Department of Homeland Security in January 2003. The Department of Homeland Security became official in March 2003 and the year 2003 was characterized by organizational challenges and a significant U.S. government transformation. Positions are being filled, organizational alignment is ongoing, and procurement practices are evolving. It is important to realize that this new department has been formed from existing agencies and their budgets, and therefore a large portion of the near-term budget is committed to heritage programs and staffing. Until some of these existing commitments are complete, funding for new opportunities will represent a small share of the overall Department of Homeland Security budget. We expect Homeland Security to be a stable market with minimal growth with emphasis being placed on Information Analysis and Infrastructure Protection.
President Bush requested $36.2 billion in the fiscal year 2004 budget request to support the Department of Homeland Security. Significantly, $18.1 billion of this request is allocated to support strategic goals of improving border security and transportation security. This area includes initiatives such as the Explosive Detection System (EDS) program, Container Security Initiatives, and technology investments for non-intrusive inspection technology. As the prime contractor for the EDS contract, IDS successfully installed EDS systems in over 400 major airports in the United States in 2002 and continues to provide support and upgrades for this program. Only 50% of the federal spending on Homeland security is within the newly formed Department of Homeland Security. Other federal agencies such as the DoD still have homeland security and homeland defense funding under their direction. IDS will continue to leverage our experience as the systems integrator on the EDS program, our aviation heritage and our Integrated Battlespace and network-centric operations expertise and capabilities in the Homeland Security marketplace.
Space exploration environment The total NASA budget is expected to remain flat over the next ten years, but it is forecasted that this budget will see a change in direction and emphasis. President Bush's vision for exploration will not require large budget increases in the near term. Instead, it will bring about a sustained focus over time and reorientation of NASA's programs. The funding added for exploration will total about $12 billion over the next five years. Most of this funding will be reallocated from existing areas as NASA reprioritizes to accomplish the President's vision. The President requested an additional $1 billion for NASA's existing five-year plan, or on average $200 million per year. We believe this allocation will be more significant in the first three years of the plan than the later two. The establishment of this new vision will provide great opportunities for industry to develop new technologies and operational concepts to take human beings beyond low-earth-orbit. IDS, with its strong heritage in the development of space systems and our expertise in the area of human space flight, including the Space Shuttle and International Space Station; is well positioned to work with and support our customer in accomplishing our goals. IDS will continue its work on the Space Shuttle and International Space Station programs along with development of critical technologies such as rocket propulsion and life support systems to prepare to meet the challenge of returning to the Moon and exploring the Solar Systems.
Launch and satellite environment The commercial space market has softened significantly since the late 1990s in conjunction with the downturn in the telecommunications industry. This market is now characterized by overcapacity, aggressive pricing and limited near term opportunities. Recent projections indicate these market conditions will persist until the end of this decade. We believe there will be lower commercial satellite orders through this decade, along with lower demand for commercial launch services. In this extremely limited market, we see a growing amount of overcapacity, which in turn is driving the continued deterioration of pricing conditions. We will continue to pursue profitable commercial satellite opportunities, where the customer values our technical expertise and unique solutions. However, we will not pursue commercial launches at a loss, and given the current pricing environment, we have decided, for the near-term, to focus our Delta IV program on the government launch market, which we believe is a more stable market.
Inherent business risks Our businesses are heavily regulated in most of our markets. We deal with numerous U.S. Government agencies and entities, including all of the branches of the U.S. military, NASA, and Homeland Security. Similar government authorities exist in our international markets.
The U.S. Government, and other governments, may terminate any of our government contracts at their convenience, or may terminate for default based on our failure to meet specified performance measurements. If any of our government contracts were to be terminated for convenience, we generally would be entitled to receive payment for work completed and allowable termination or cancellation costs. If any of our government contracts were to be terminated for default, generally the U.S. Government would pay only for the work that has been accepted and can require us to pay the difference between the original contract price and the cost to re-procure the contract items, net of the work accepted from the original contract. The U.S. Government can also hold us liable for damages resulting from the default.
On February 23, 2004, the U.S. Government announced plans to terminate for convenience the RA-66 Comanche contract. Boeing and United Technologies each had a 50% contractual relationship in the program. The announcement did not have an impact on 2003 financial results. The program represented less than 1% of our projected 2004 revenues.
U.S. Government contracts also are conditioned upon the continuing availability of Congressional appropriations. Long-term government contracts and related orders are subject to cancellation if appropriations for subsequent performance periods become unavailable. On research and development contracts, Congress usually appropriates funds on a Government-fiscal-year basis (September 30 year end), even though contract performance may extend over years.
Many of our contracts are fixed-price contracts. While firm, fixed-price contracts allow us to benefit from cost savings, they also expose us to the risk of cost overruns. If the initial estimates we use to calculate the contract price prove to be incorrect, we can incur losses on those contracts. In addition, some of our contracts have specific provisions relating to cost controls, schedule, and product performance. If we fail to meet the terms specified in those contracts, then we may not realize their full benefits. Our ability to manage costs on these contracts may affect our financial condition. Cost overruns may result in lower earnings, which would have an adverse effect on our financial results.
Sales of our products and services internationally are subject not only to local government regulations and procurement policies and practices but also to the policies and approval of the U.S. Departments of State and Defense. The policies of some international customers require "industrial participation" agreements, which are discussed more fully in the "Disclosures about contractual obligations and commitments" section.
We are subject to business and cost classification regulations associated with our U.S. Government defense and space contracts. Violations can result in civil, criminal or administrative proceedings involving fines, compensatory and treble damages, restitution, forfeitures, and suspension or debarment from U.S. Government contracts. We are currently in discussions with the U.S. Government regarding the allocability of certain pension costs which could be material. It is not possible at this time to predict the outcome of these discussions.
767 Tanker Program The U.S. Government is currently reviewing the USAF proposal for the purchase/lease combination of 100 767 Tankers. Discussions between the USAF and us have been paused, while a series of U.S. Government reviews is undertaken. As a result, on February 20, 2004, we announced that we will slow development efforts on the USAF 767 Tanker program. This slow down will result in the layoff of 100 contract employees and 50 employees, redeployment of certain other personnel, and an extension of the USAF 767 Tanker production schedule. Our current expectation is that it is probable we will receive the USAF tanker order in 2004. In the event the order is not received, we would write off tanker-related capitalized costs, and incur supplier termination penalties. On a consolidated basis, our potential charges would be $261 million as of December 31, 2003, consisting of $176 million related to the Commercial Airplanes segment, and $85 million related to the A&WS segment. Our total potential termination charge could reach approximately $310 million by March 31, 2004. (See Commercial Airplanes Accounting Quantity for related discussion.) Additionally, the outcome of the USAF proposal could also have an adverse impact on our margins associated with Italian and Japanese tanker contracts. The outcome of the USAF proposal could also have an impact on the amount of research and development expenditures that we would have to recognize.
Sea Launch The Sea Launch venture, in which we are a 40% partner, provides ocean-based launch services to commercial satellite customers. In 2003, the venture conducted three successful launches with precision payload delivery in orbit. The venture continues to aggressively manage its cost structure. The venture is impacted by the commercial launch market risk discussed in the "Launch and Satellite Environment" section.
We have previously issued credit guarantees to creditors of the Sea Launch venture to assist the venture in obtaining financing. In the event we are required to perform on these guarantees, we have the right to recover a portion of the loss from other venture partners, and have collateral rights to certain assets of the venture. We believe our total maximum exposure to loss from Sea Launch totals $226 million, taking into account recourse from other venture partners and estimated proceeds from collateral. The components of this exposure include $188 million ($801 million, net of $416 million in established reserves and $197 million in recourse from partners) of other assets and advances, $26 million for potential subcontract termination liabilities, and $12 million ($30 million net of $18 million in recourse from partners) of exposure related to performance guarantees provided by us to a Sea Launch customer. We also have outstanding credit guarantees with no net exposure ($519 million, net of $311 million in recourse from partners and $208 million in established reserves). We made no additional capital contributions to the Sea Launch venture during the year ended December 31, 2003.
Delta IV In 1999, two employees were found to have in their possession certain information pertaining to a competitor, Lockheed Martin Corporation, under the Evolved Expendable Launch Vehicle (EELV) Program. The employees, one of whom was a former employee of Lockheed Martin, were terminated and a third employee was disciplined and resigned. In March 2003, the USAF notified us that it was reviewing our present responsibility as a government contractor in connection with the incident. In June 2003, Lockheed Martin filed a lawsuit against us and the three individual former employees arising from the same facts. It is not possible at this time to predict the outcome of these matters or whether an adverse outcome would or could have a material adverse effect on our financial position. In addition, on July 24, 2003, the USAF suspended certain organizations in our space launch services business and the three former employees from receiving government contracts for an indefinite period as a direct result of alleged wrongdoing relating to possession of the Lockheed Martin information during the EELV source selection in 1998. The USAF also terminated 7 out of 21 of our EELV launches previously awarded through a mutual contract modification and disqualified the launch services business from competing for three additional launches under a follow-on procurement. The same incident is under investigation by the U.S. Attorney in Los Angeles, who indicted two of the former employees in July 2003.
Satellites Many of the existing satellite programs have very complex designs including unique phased array antenna designs. As is standard for this industry these programs are also fixed price in nature. As technical or quality issues arise, we have continued to experience schedule delays and cost impacts. We believe we have appropriately estimated costs to complete these contracts. However, if a major event arises, it could result in a material charge. These programs are on-going, and while we believe the cost estimates reflected in the December 31, 2003 financial statements are adequate, the technical complexity of the satellites create financial risk, as additional completion costs may become necessary, or scheduled delivery dates could be missed, which could trigger Termination for Default (TFD) provisions or other financially significant exposure.
Additionally, in certain launch and satellite sales contracts, we include provisions for replacement launch services or hardware if we do not meet specified performance criteria. We have historically purchased insurance to cover these exposures when allowed under the terms of the contract. The current insurance market reflects unusually high premium rates and also suffers from a lack of capacity to handle all insurance requirements. We make decisions on the procurement of third-party insurance based on our analysis of risk. There is one contractual launch scheduled in late 2004 for which full insurance coverage may not be available, or if available, could be prohibitively expensive. We will continue to review this risk. We estimate that the potential uninsured amount for this launch could be approximately $100 million.