An interview with Sergei Batekhin, General Director of IFIG Defense Systems, on ways of increasing the investment attractiveness of the defense industry.

 What was the year 2001 like for IFIG Defense Systems?

Last year was quite difficult for the entire Russian defense industry, including our company. You know that there is a certain cyclic nature to the operation of defense plants. The implementation of defense contracts takes several years; therefore changes in sales volumes can be described by a sinusoid. There have been such fluctuations in sales volumes at our company as well, and in 2001 we were at the lowest point of the cycle. Still we ended the year with a profit.

The main achievements of last year were that we made headway on new products and found a new place for Defense Systems in the defense industry complex. During the year we had to find a new mission for the company, a new niche, to restructure our entire business to remain in our market segment. You know that initially Defense Systems emerged as the core contractor in exporting the S-300 (SA-10) medium range surface-to-air missile systems. After the government decided to hand over the role of the core contractor to another company, Almaz Central Design Bureau, it became clear that the sales volumes previously channeled through Defense Systems would no longer be possible. The functions of the company changed fundamentally. Earlier we managed the entire production chain on the S-300. A very big job was done in 2000-2001 to form a new production chain for the new Pechora-2 surface-to-air missile system. We already have a contract for it. The system is now approaching the final stage of range tests and in April we plan to transfer it to our foreign customer. Deliveries will begin this year and our sales volumes will increase.

How can these ups and downs in sales volumes be eliminated?

The main reason for the ups and downs in sales lies in the fact that there remains an excessively high share of purely military output in the Russian defense industry. For instance, in our group the share of arms and military hardware exceeds 90%. We are trying to diversify our product range by supplementing the manufacture of weaponry with dual purpose and civilian goods. We hope that in two to three years the correlation between military and civilian output will be 60/40 in favor of defense goods.

In the past we closely studied the possibility of promoting products developed on the basis of defense technologies and concluded that there was demand for positioning systems. As you know any air defense system before assuming combat position should check its whereabouts. In the past such systems would occupy a whole heavy duty truck. When we started making the Phoenix short-range passive surveillance system, we faced the need to reduce the weight and size of the positioning equipment. A system was developed relying on satellite navigation (both NAVSTAR and GLONASS), the digital maps of various international companies plus our software and our system of data recording and processing.

The invention may be used not only for defense purposes but also in everyday life. So far it has already been ordered by the Main Department of Corrective Institutions. The system can be applied on ambulances, for the security of private individuals, and to monitor freight vehicles. It allows one not only to monitor truck movements but also to see what is happening to them – whether they are operational or not, whether their doors are open or not. This option is also attractive for the Railway Ministry and even construction companies. Their concrete trucks deliver only 30-40% of the loaded concrete to the construction sites the rest is pilfered on the way. The experimental application of the system immediately helped to resolve the problem of controlling construction material reserves. The military use the system for surveillance. We find the market of these devices very promising.

Yes, we have to admit the fact that Defense Systems did not become the center of integrating designers and manufacturers working on the S-300P. Today this is clear to everyone. It is impossible to say for sure why this happened, or whether it is good or bad. I think that Defense Systems had carried out all its tasks in previous years, namely, to secure the fulfillment of financially, technically and politically demanding contracts for the S-300. By the way, it should not be forgotten that the role of the core company was assigned to Defense Systems by companies in the industry. In those times the current system of determining the core company did not exist. Now the main contractor is chosen by the government. Earlier this was done by a meeting of company directors.

It seems to me that the main reason for the transition of the role of the core company from Defense Systems to Almaz was that we are a private entity while Almaz is controlled by the government. Two years ago we suggested transferring controlling shares to the state and thus building a vertically- integrated corporation on the basis of Defense Systems. However, we failed to carry out the idea, partly due to the resistance of competitors but mainly because the government failed to adopt a legal mechanism of transferring a stake in a private company to the state. There is a mechanism of privatization but there is no transfer mechanism in the opposite direction.

In general it must be said that selling the S-300 is a government business. For the simple reason that the system was built with public money and 80% of the industrial facilities and participants in the project are government-owned enterprises. Clearly the state being the core owner of the manufacturers of the system and having paid for its development has the right to decide who should be selling them. Therefore it is correct from the viewpoint of the government to appoint a government-controlled enterprise as the core contractor - this arrangement allows the retention of full control. Time will tell whether such control is going to be effective. After failing to resolve the problem of transferring a sufficient stake to the state Defense Systems couldn’t claim the role of the main contractor in new deals, although the plant owned by Defense Systems, Moscow Radio Engineering Plant (MRTZ), remains in the production chain. We are still actively involved in the process of forming production chains of the facilities we own to carry out the well-known export contract for the S-300 (the $450 million contract for the S-300PMU with China).

From the viewpoint of private capital everything is alright with us. One cannot be sure whether it is better to be a clear and understandable private group or to transfer controlling shares to the state and sit waiting for the next reshuffle. From the viewpoint of private business there has been no failure. As I have said we remain strongly convinced that the arms trade is a government business and the role of the government in it should be maintained. It is another thing that I would distinguish between the notions of control and ownership. For some reason our officials believe that government control can be guaranteed only through controlling shares. I think this approach is wrong. The main problem is different – it is the shortage of investment resources. I want to repeat that government control in the military industrial complex the need for which nobody disputes should not be mixed with primitive ownership.

It is a different matter that from a managerial point of view we flopped by failing to persuade the government that we are effective managers. Process management is as an important production factor as investments, manpower and capital assets. If one proceeds from this concept, I think that it was a loss for everyone that Defense Systems no longer heads the production chain. I think that our efforts to develop cooperation chains and fulfill expert contracts for the S-300 proved that we are strong managers. The people who will now be in charge of cooperation will have to cover the whole road from the very start. By the way, we actually remain involved in the process of organizing production under the latest export contract both in our own interests and for the benefit of the state.

When Yakov Urinson was the economics minister, the approach to the defense industry was the same as to any other sector of the economy. There was the belief that there was a market and all companies should be thrown into it and each company should then try to survive. Therefore there simply was no sensible policy in the defense complex. Even though this approach had its own advantages. Several private companies as well as state enterprises managed to adapt to those conditions and become quite effective economic entities.

Three years ago when the government attitude to the defense industry changed, it was decided to develop a certain government policy for the industry. And that was probably correct. After that the government needed time to find out what was actually going on. The proprietor was checking out his property, seeing who owned and managed what, developing the mechanism of appointing managers. When much property lands in your hands, it takes a long time to sort things out. Then priorities had to be chosen. In the person of agencies the government came to realize what it had, what it wanted and where it was going to. This is already a result. And now the stage is beginning when a dialogue should be started between the private sector and the state, between the financial and production sectors on how to revive the defense industry. That was impossible until this day.

I think a last chance remains and we should jump into the last carriage of the departing train. All the prerequisites have been created. The program of armaments until 2010 had been adopted that defines technical priorities and determines the choice of the necessary productions. Overlapping will be eliminated; the implementation of the program will result in the closure of redundant production capacities. The reform program for 2002-2006 defines the configuration of holdings and concerns by sectors in conformity with the program of armaments. The system of military-technical cooperation has been reformed. A policy of reducing the number of participants in military-technical cooperation has been adopted. Correspondingly the state is assuming control over this channel as well. It can now decide which enterprises necessary for satisfying domestic needs will be given export orders.

The main question of the day is to attract financial resources to the defense industry. If it is realized that this is the main task of the defense industry, this will not only guarantee the survival of the defense industry but make it the locomotive of the entire economy. Today there are not so many sources of funds for the defense industry. The first is the government defense order. It is limited and insufficient to support the entire defense industry. The second is export. However, it does not satisfy all the survival needs of the defense industry either. Besides, the needs of foreign customers don’t always coincide with the needs of the Russian Armed Forces. However, there is still no mechanism of channeling part of export returns to R&D. The third source is the government budget in the form of target programs. However, all these sources do not guarantee the normal development of the defense industry.

Resources for the defense industry can come only from the stock market. It can be only private money. But today investments in the defense industry are understood as investments in a certain munitions plant. No reasonable sober-minded investor will invest his free resources in a defense plant. The problem of secrecy and the absence of restructuring at the enterprises themselves stand in the way. All facilities have enormous redundant capacities that determine their technological unprofitability. When the Soviet Union built defense plants, it proceeded from the need to manufacture large series of products and nobody counted the resources required for either the construction of facilities or serial production. Today the restructuring of a plant requires primarily resources. The next limitation is the wear and tear of capital assets. Therefore one should not expect direct money investments in defense plants. Besides, the program of diversifying production is not working either. Defense industry facilities are technologically unfit to make civilian goods - they are too expensive. On the other hand, to keep up the current production structure is a road to nowhere.

T wo things should be done. Firstly, the investment of private money in defense-related R&D should be allowed. Secondly, the defense sector should be made attractive for private investors. Today there is no mechanism that would allow investing private money in R&D or some other military program instead of the purchase of assets. This is prohibited by law. The State Duma thinks that non-government money cannot be invested in defense-related areas. In our opinion, this is a mistake. If private companies are not allowed to invest in development, the defense industry will remain unattractive for investments.

Only diversification can increase the investment attractiveness of the defense industry. However, not only the output (when a tank plant begins producing pans or spades) but share ownership should be diversified. Managing companies in the defense sector should be allowed to own attractive assets in non-military sectors. For instance, Defense Systems could buy a filling station or an oilfield. Then there would be diversification not in the sense that we would be making civilian goods at MRTZ but through the ownership of non-military assets.

Because what we have now is as follows. The entire economy is already in market conditions while the defense industry has one foot in market conditions and the other back in socialism. The distance between the two is steadily increasing, so soon we will make a split risking to tear our trousers. Therefore we should pull ourselves together and bring the second foot to the market. Today the government is building up AMIC Sukhoi that will own almost solely defense assets. But why shouldn’t the government transfer to it its stakes in industries more attractive for investors, for instance, in the fuel and energy sector? This would allow reducing the share of military production in the overall volume of cash flows of the managing company of the group and increasing the civilian production of commodities.

No, the idea is different. The main thing is that it would make the shares of defense companies more attractive, increase the capitalization of the defense industry and attract investment resources from the stock market. An investor knowing that AMIC Sukhoi stands not simply for the manufacture of aircraft but something understandable, not subjected to secrecy or cyclic nature, will invest in the company. It is not the low profit rates of the defense industry that scare everyone off but its cyclic production nature, secrecy and the possibility of government interference. For instance, if you take a look at the Boeing output structure, you will see that farming constitutes 30% of sales.

Thus the idea is to attract investment resources to the defense sector through diversifying assets that are owned by management companies that have evolved in the defense industry.

You are absolutely right. And here we get back to the subject of concerns, for instance, a concern in the air defense systems industry. Today the dispute is no longer over whether it should be formed or not, that dispute is over and everyone has agreed with the need for setting up the concern. The current argument is over a different matter – on the basis of which company should the concern be developed and who should manage it. I can give you one hundred reasons why a design bureau should head it and one hundred reasons why the concern should be set up on the basis of a serial plant. It is unpleasant that even the president has already been convinced that corporate structures should be built on the basis of operating companies. The simple argument is that there is no need for a mediator. I think this is pure populism. Firstly, a management company is an absolutely separate business that has nothing to do with either development or production. Management is an absolutely different process. Take show business. In Soviet times we all knew who the poet was, who wrote the lyrics and who composed the music. Now the main person in show business is the producer who orders the music. The pattern is approximately the same in other branches of the economy as well. And the defense industry should not be torn away from the rest of the economy. A management company today is becoming the main link of restructuring the defense industry. Only a management company is capable of resolving the problem of attracting resources from the stock market. Firstly, it is not subject to the negative consequences which defense production faces: the wear and tear of production assets, the aging of the personnel, debts, and unrestructured production. A management company is the only tool that can be used to diversify assets. It should become an effective, mobile, attractive brand for entering the market of private investment resources.

Firstly, the government should set the rules of the game. It is essential that the government realized that control over arms production is not tantamount to ownership. Secondly, the government should lift restrictions on attracting private money not only from domestic but also from foreign sources. The government should support management companies. After all there is no license for management today. Defense Systems had to approach MRTZ and assume ownership over production assets due to the imperfection of our legislation and licensing. This is not our problem, it is the problem of any management company in the defense industry. AMIC Sukhoi in the form it exists today should get a license not for developing or manufacturing arms but for management. Later the government should think how to transfer other assets - not only defense ones - to such companies allowing them to attract private money.

I think that the pendulum that first swung in the direction of extreme liberalization and after 1998 in the direction of strong government regulation should now start moving backward. The government itself has declared as its purpose to establish holdings and then sell them. The question is different – who needs these holdings? They have not been restructured. Restructuring requires resources and resources will flow only to restructured companies. We get a vicious circle. It is clear that exports will allow them to survive but export resources will not be sufficient for restructuring, the replacement of capital assets and advancement.

It thinks it does have something. By the way, one can approach the matter from the opposite end by adding shares of a defense industry facility to other assets.

I think resources can be attracted, if the rules of the game are worked out and agreement is reached with private financial and industrial groups. All these groups –Unified Energy Systems, Gazprom, Norilsk Nickel, the oil companies - are approaching the need for sweeping technical modernization. The question is who will carry it out – Western companies or the domestic defense industry. The government should think of its priorities in its industrial policy and probably create a mechanism of stimulating the domestic high tech sector. I realize that privileges are unpopular today. But on the other hand, I think one should stimulate Gazprom or Norilsk Nickel and the procurement of domestically made products and also the involvement of big corporations in defense industry capital.